Trading Psychology Explained6 min read

Trading Psychology Explained

As humans, investors use their brains and heart to be in the best market position. 

However, not everyone can control, train and use their mental capabilities with instincts to book a profitable position in the securities market.

Market sentiment is the result of the psychology of individual investors to achieve the best outcome in the market, aggregated to know the overall psychological movements in the price and volume actions. 

What role does psychology play in trading? 

Trading psychology is majorly the emotional and mental part of an investor’s decision-making process. The emotional component affects the investor’s decision highly and thus the success or failure of the decision depends on traders’ psychological factors.

Knowing rationale behaviour and accommodating your emotions to it leads to better results than just relying on the hit and trial rule of emotions and instincts. 

The before outcome emotion is hope and after the outcome, emotion can be regret or suffice. That’s how trading can be viewed via the psychological lens.

Psychology trading is developed with the discipline and risk-taking capabilities of individual investors.

Markets being extremely volatile, and human behaviour being extremely unpredictable and diverse, the collusion between the two sets of aspects leads to decision-making over market positions.

However, the market positions can be long, short or stay while addressing the volatility with the mental state of the investor.

We have seen the market as a whole, a lot of investors are thrown out of the market due to their panic-driven decisions. 

These panic-driven decisions come from a lack of handling the emotional capacity of investors, therefore, looking at the markets with just one lens of psychology. 

Suppose your instincts predict a market uptrend but the technical analysis of the present market predicts a downward price movement. If the investor losses rationality and goes just by the emotional instinct, the decision would be to hold the present position. 

This might lead to a loss-making outcome and again trading psychology loop continues as now the emotion that prevails is regret. 

The regret might induce panic and thus block the rational decision-making power of the investor once again. 

Components of trading psychology

Psychology trading majorly revolves around two of the highest associated emotions, that is fear and greed. These two emotions are given the top importance for trading psychology as they perform catalysts functions to determine trading direction and magnitude.

  1. Greed – is a basic sense, greed is one of the factors that brings a common savings person into the investment world. The greed for earning more.

This greed or the emotion to just earn more and more often clouds rationality. And once the ship gets into the storm, without the safety kit, the results are often disappointing. 

In trading, one might buy stocks at high risk just because they saw high profits for one quarter. 

Relying on instincts that the security will book profits no matter how weak fundamentals are and how contradictory investment research is, refers to the greed aspect of investment decision. 

The greed aspect generally prevails in bullish markets, when prices move in an uptrend for a long period and you feel let’s wait for some more rise but now the reversal trends follow up, leading to losses due to greed. 

Now, the psychological game is retrospective in the sense that once the loss has occurred, some might flow the emotional direction towards more trade action to recover the loss. Again, knowingly taking risks over disastrous circumstances due to revenge trading psychology. 

  1. Fear – as greed lets people stay more into a certain position than advisable, fear induces early to back off from current trading positions.

Fear of losing in the next step and being fine with current low trades again leads to irrational decisions. 

Fear can be off falling prices and therefore panic selling can be the decision. Fear clouds the rational thinking capacity by creating false low-market expectations than the actual trend. 

Risk bearing and setting a plan according to individual capacity requires market study with an open mind.

In a bearish trend, the trader might sell off at low positions due to fear of more downfall, and the trend me reverse to an uptrend. This leads to losses induced by irrational thinking under fear pressure. 

How biases affect trading 

Biases in trading are a predetermined personal disposition majorly favouring one thing over another.

Now as we are aware of how emotions create a psychological impact on our trading decisions, we can observe them as biases. 

Certainly fear and greed are the most important factors but not the only factors. Therefore before we move on to reducing emotional trading, we got to understand how biases affect trading decisions. 

Types of biases and their effects:-

  1. Representative bais – representative in a literal sense would mean to be a similar state as experienced earlier. Suppose an investor held ₹ 50,000 Tata Ltd shares that proved to be much more profitable under normal inflationary conditions. Now the investor if clouded under a representative bias, might follow or replicate his decision of holding ₹ 50,000 into Tata Ltd even under high inflationary conditions just because they booked him a profit in earlier trade actions. 
  2. Negative bias – negative bias means being a negative thinker and losing gains. Just when your whole investment plan needed small corrections to change losses into gains, you scrapped the full plan. This is a negative biased decision. Looking only at the negative side of the market and not the overall market sentiment. 
  3. Status quo bias – in simplified terms, this means to be using your all-time convenient and favourite strategies of investment everywhere repeatedly. The dangerous component of this bias is that not always do the old strategies fit into the current markets and therefore exploring new ones is important. This type of bias is known as status quo bias. 
  4. Confirmation bias – when you as an investor prepare your analysis, get some news that just complements your analysis and shoot your shot, may prove risky. This is because you might tend to ignore the contradictory facts due to confirmation bias. 

How to minimise biases while trading 

  1. Identify your emotional intelligence – knowing yourself is the first and foremost step in minimising the impact of psychological biases in your investment decision. Knowing when you get scared and feel confident about price movements and jotting down the instances will help you understand the correlation between your emotional intelligence and market predictability. 
  2. Develop a trading plan – mostly, investors develop trading plans practically depending upon just the market indicators. The more perfect way of developing is to accommodate psychological factors as well. Like building a plan where you write rational decisions to be taken in what conditions and your instincts decision making intelligence. It would be easy to compare both. 
  3. Patience – the first rule of trading is patience over panic anytime. Patience while understanding the market, understanding emotions, and understanding market decisions and consequences would lead you to the closest prediction of future trading actions for a higher benefit. 
  4. Adaptiveness – as an investor, you should follow a rule of thumb, that is being adaptive to highly sensitive markets. Changing as per dynamic market and being highly active while adapting to the current market. 


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