What is Trading Psychology?

Trading psychology refers to the emotions and mental state that help to dictate success or failure in trading securities. Trading psychology represents various aspects of an individual’s character and behaviors that influence their trading actions. Trading psychology can be as important as other attributes such as knowledge, experience and skill in determining trading success.

Discipline and risk-taking are two of the most critical aspects of trading psychology, since a trader’s implementation of these aspects is critical to the success of his or her trading plan. While fear and greed are the two most commonly known emotions associated with trading psychology, other emotions that drive trading behavior are hope and regret.

Key Takeaways

  • Trading psychology is the emotional component of investor's decision making process which may help explain why some decisions appear more rational than others.
  • Trading psychology is characterized primarily as the influence of both greed and fear.
  • Greed drives decisions that appear to accept too much risk.
  • Fear drives decisions that appear to avoid risk and generate too little return.

Understanding Trading Psychology

Trading psychology can be associated with a few specific emotions and behaviors that are often catalysts for market trading. Conventional characterizations of emotionally-driven behavior in markets ascribe most emotional trading to either greed or fear.

Greed can be thought of as an excessive desire for wealth, so excessive that it clouds rationality and judgement at times. Thus this characterization of greed-inspired investor or trading assumes that this emotion often leads traders towards a variety of behaviors. This may include making high-risk trades, buying shares of an untested company or technology just because it is going up in price rapidly, or buying shares without researching the underlying investment.

Additionally, greed may inspire investors to stay in profitable trades longer than is advisable in an effort to squeeze out extra profits from it, or to take on large speculative positions. Greed is most apparent in the final phase of bull markets, when speculation runs rampant and investors throw caution to the wind.

Conversely, fear causes traders to close out positions prematurely or to refrain from taking on risk because of concern about large losses. Fear is palpable during bear markets, and it is a potent emotion that can cause traders and investors to act irrationally in their haste to exit the market. Fear often morphs into panic, which generally causes significant selloffs in the market from panic selling.

Regret may cause a trader to get into a trade after initially missing out on it because the stock moved too fast. This is a violation of trading discipline and often results in direct losses from security prices that are falling from peak highs.

Technical Analysis

Trading psychology is often important for technical analysts relying on charting techniques to drive their trade decisions. Security charting can provide a broad array of insights on a security’s movement. While technical analysis and charting techniques can be helpful in spotting trends for buying and selling opportunities, it requires an understanding and intuition for market movements which is derived from an investor’s trading psychology.

There are numerous instances in technical charting where a trader must rely not only on the chart’s insight but also their own knowledge of the security that they're following and their intuition for how broader factors are affecting the market. Traders with a keen attention to comprehensive security price influences, discipline and confidence show a balanced trading psychology that typically contributes to profitable success.