Many skills are required for trading successfully in the financial markets. They include the abilities to evaluate a company's fundamentals and to determine the direction of a stock's trend. But neither of these technical skills is as important as the trader's mindset.
Containing emotion, thinking quickly, and exercising discipline are components of what we might call trading psychology.
There are two main emotions to understand and keep under control: fear and greed.
Traders often have to think fast and make quick decisions, darting in and out of stocks on short notice. To accomplish this, they need a certain presence of mind. They also need the discipline to stick with their own trading plans and know when to book profits and losses. Emotions simply can't get in the way.
- Overall investor sentiment frequently drives market performance in directions that are at odds with the fundamentals.
- The successful investor controls fear and greed, the two human emotions that drive that sentiment.
- Understanding this can give you the discipline and objectivity needed to take advantage of others' emotions.
When traders get bad news about a certain stock or about the economy in general, they naturally get scared. They may overreact and feel compelled to liquidate their holdings and sit on the cash, refraining from taking any more risks. If they do, they may avoid certain losses but may also miss out on some gains.
Traders need to understand what fear is: a natural reaction to a perceived threat. In this case, it's a threat to their profit potential.
Quantifying the fear might help. Traders should consider just what they are afraid of, and why they are afraid of it. But that thinking should occur before the bad news, not in the middle of it.
Fear and greed are the two visceral emotions to keep in control.
By thinking it through ahead of time, traders will know how they perceive events instinctively and react to them, and can move past the emotional response. Of course, this is not easy, but it's necessary to the health of an investor's portfolio, not to mention the investor.
There's an old saying on Wall Street that "pigs get slaughtered." This refers to the habit greedy investors have of hanging on to a winning position too long to get every last tick upward in price. Sooner or later, the trend reverses and the greedy get caught.
Greed is not easy to overcome. It's often based on the instinct to do better, to get just a little more. A trader should learn to recognize this instinct and develop a trading plan based on rational thinking, not whims or instincts.
A trader needs to create rules and follow them when the psychological crunch comes. Set out guidelines based on your risk-reward tolerance for when to enter a trade and when to exit it. Set a profit target and put a stop loss in place to take emotion out of the process.
In addition, you might decide which specific events, such as a positive or negative earnings release, should trigger a decision to buy or sell a stock.
It's wise to set limits on the maximum amount you are willing to win or lose in a day. If you hit the profit target, take the money and run. If your losses hit a predetermined number, fold up your tent and go home.
Either way, you'll live to trade another day.
Conducting Research and Review
Traders need to become experts in the stocks and industries that interest them. Keep on top of the news, educate yourself and, iif possible, go to trading seminars and attend conferences.
Devote as much time as possible to the research process. That means studying charts, speaking with management, reading trade journals, and doing other background work such as macroeconomic analysis or industry analysis.
Knowledge can also help overcome fear.
It's important for traders to remain flexible and consider experimenting from time to time. For example, you might consider using options to mitigate risk. One of the best ways a trader can learn is by experimenting (within reason). The experience may also help reduce emotional influences.
Finally, traders should periodically assess their own performances. In addition to reviewing their returns and individual positions, traders should reflect on how they prepared for a trading session, how up to date they are on the markets, and how they're progressing in terms of ongoing education. This periodic assessment can help a trader correct mistakes, change bad habits, and enhance overall returns.