Trading psychology plays a big role in determining whether you’ll be a big loser or a big winner in the stock market over time. Success in markets depends on how well you are able to identify and control the human element in trading. The ability to understand your emotions and recognize herd mentality can prove to be a successful strategy all on its own. This article highlights the emotional mindsets that traders exhibit when interacting with the market.
Identifying Losing and Winning Trades
Being successful in the market requires basic a understanding that you need to make money, and more importantly, you have to protect that money. Achieving this is easier said than done and most often counterintuitive to the theory of trading and investing. More on that, a trader must must sell losing trades early and let winning trades go long. In the market, most people tend to sell their winning trades early before they have maximized profit potential. On the other hand, those same traders will hold a losing trade too long, saying things like “I’ll just hold on until it shows a profit”.
An unexperienced trader will realize (cash out) a 5% profit and hold on to a 30% loss, this strategy will likely lead to large losses. A loss of opportunity arises when the trader holds on a the loss for an extended period of time; the capital is tied up in the losing trade and cannot be repurposed in a better performing asset or security.
Fear of Missing Out (FOMO)
FOMO will cause traders to react impulsively without thinking about anything relative to the market itself. Your friend bought the stock, your aunt bought it, and even that guy at Walmart who mentioned it in the checkout line. And you felt that you had to buy it too, how could you not right? Everyone else has it and what if it goes up? You’d have no one to blame but yourself.
Maybe the stock even went up 2% yesterday, that’s all the research you need. So without thinking about the market, the stock in question, the economy, or your finances, you go all in. Maybe it pans out but maybe it doesn’t. If you follow everyone else jumping off the bridge without checking over the edge, you may find greener pastures, or you may find a highway. You’re at the mercy of others and the market if you choose to trade in this fashion.
Whispers From A Higher Power
These whispers can come from anyone and anywhere, we’ve all heard them. “Hey, have you heard of ABC Industries? The stock is pre-revenue but I got a good tip from a friend of mine who’s in finance, he said it should triple by year end”. Unlike FOMO, no one is talking about this stock, after all everyone knows the biggest gainers in the market are those that nobody’s talking about, right?
Well it depends on the company, the industry, its prospects of profitability, and of course who’s managing the company. But does any of that matter if you hear about this opportunity from a friend of a friend that works in finance? Don’t be surprised if things don’t go according to plan, when you take a step back and look at this situation, it was all quite the pipe dream.
“It’s only a $1,000 investment, worth the risk”
“I know it’s risky but I’m only investing $1,000, if I lose it no big deal”. “I would never invest a lot of money in a company like this”. Some traders treat $1,000 differently than they treat $100,000. All money should be treated the same because money is money, no matter the amount. How does one expect to get to $2,000 if they continue to make risky trades with their hard earned $1,000? Maybe if some traders knew how to protect $1,000, they could generate tens of thousands or even hundreds of thousands relatively easily. If you ever feel like you need to get rich quick, please don’t trade in the stock market. There are plenty of market manipulators who are capitalizing on defrauding traders of this type in the market.
Happy When Showing a Profit, Sad When Showing a Loss
Times are good and you’re all smiles when your position shows a profit. When times are bad and you are showing a loss on your position, you are as sad as can be. This mentality may cause the trader to lose focus on the happy side, and doubtful of their abilities on the sad side. To be successful, a trader must feel the same way about a loss as he/she feels about a profit. In this way, the trader can stay focused on his/her trading plan, risk management, and goals.
If you become too elated when your position shows a profit, this may lead to you thinking that everything you touch turns to gold. This would lead to poor trading decisions as you try to leverage your profitable positions on more risky ones. On the other hand, if you become angry when you have losing positions, you might become negative on the market. You may never trade again or you might make a riskier investment in hopes that it shows a profit to offset your losing position.
A good way to avoid many of the pitfalls of human psychology when interacting with the stock market is to have a trading plan or risk management process. A set of rules will eliminate any human emotion from entering into the market with your hard-earned money.
Even a basic rule like avoiding the stock market on ‘expiration Friday’ can provide a base for a strategy that avoids volatile markets. Your trading plan can be as simple or complex as you like, the more complex the strategy, the less likely decisions will be made on emotions.