There are lots of reasons for making psychological mistakes when trading in financial markets. The recent lock-down experience has witnessed an explosion in the number of day traders seeking to capitalise on increasingly volatile markets in addition to others seeking to make financial trading a source of additional income or as a means of changing their career. This has been a liberating experience for some, in seeking to create greater freedom and autonomy in their lives and to get away from a restrictive corporate culture, but has been a difficult time for others who have experienced a baptism of fire getting to grips with a new world with many pitfalls.
This post emphasises the psychological mistakes in trading rather than necessarily the technical trade management mistakes (although one usually leads to the other) and will apply to traders even with robust trade management tools and adequate safeguards in place. This post also draws a distinction between a trader and a long term investor. The latter is seeking out long term investment potential and is typically intending to buy and hold, whilst the former is typically in search of a short term profit based on technical movements in price. This post will be less useful to problem gamblers. Trading that is doomed to failure is when a problem gambler is seeking a thrill by playing the markets. Your trading account will inevitably suffer if you engage in the activity for the thrill of the chase, or to escape emotional pain elsewhere in your life.
Successful financial trading invariably involves specialisation and not trading in unfamiliar products or markets. It also involves the ability to practice patience whilst sitting on cash and waiting for opportunities to present themselves, rather than hunting for opportunities in unfamiliar markets. Producing a green profit and loss account involves taking advantage of opportunities that present themselves, where you think that you have an edge in the market. Or, it might entail waiting for a cycle to appear and taking advantage by following a trend, a so-called momentum trade.
A good trader will adapt to changing market conditions such as greater levels of high frequency trading and the use of trading algorithms in the market rather than complain about the difficult market conditions presented by such innovations. So-called ‘algo’ trading is not the reason why your profit and loss account has produced a negative return, in the same way that the introduction of telephone trading and the use of computers in the past had apparently caused negative returns for traders back in the day. Successful trading necessitates being able to adapt to changing market conditions and learning to employ updated strategies.
Outlined below are common psychological mistakes made by traders seeking to make a profit.
1. Engaging in cognitive biases when trading
The collection of faulty ways of thinking, such as jumping to conclusions, tunnel vision thinking, seeing things in black and white, can feel like they are hard-wired into the human brain. However, we can pause and think twice before deciding what to do so that we do not make decisions with such a negative bias.
Financial traders who display symptoms of problem behaviour often show a consistent bias when it comes to placing trades. They typically display a bias to sell (short) or to buy (to go long and hold), or can be biased about the type of market they will trade, or indeed whether they are a trend follower or a contrarian investor. A bias may prove profitable in the short term but over the longer term such biases can be the main reason for negative returns. Successful traders, on the other hand, won’t have such a prominent default bias. They will remain flexible and will more likely assess trading options from a relatively neutral perspective and consequently will have an unbiased stance when assessing options.
Cognitive biases often persist especially after a bull run (when a trend seems to be on a solid upward trajectory) but can also be problematical after a serious correction (when a continuing downward trend seems apparent). In volatile markets it is imperative to be aware of cognitive biases in order to be best placed to take advantage of new opportunities.
2. Being a slave to the charts
Historical data of markets showing trends may hold vital intelligence on the potential future movement of prices but it is important to stay mindful that new trends can emerge at any point. Traders will often say that they have an instinct for spotting and predicting market moves but can struggle with the discipline needed in waiting for such movements. Sitting on fingers and going to cash can be challenging especially when the fear of missing out on a profitable trade takes hold. The fear of missing out usually leads to irrational decision making in most decision making processes, especially in financial trading.
Successful traders embrace the ‘here and now’ and engage with people around them as they let go of screen watching for periods within a trading day. They will also remind themselves that another opportunity is around the corner, even if they have missed out on taking advantage of a previous buy signal.
3. Chasing losses
Losing money is never a pleasurable experience but even the best traders have losing trades. Losing is inevitable. However, we feel the pain of losing more than we feel the pleasure of a win. That might explain the reason for the phenomenon of chasing. Chasing is essentially the process of doubling up, seeking to reclaim past losses in a rapid fashion by going for the big win. In its most distorted form this kind of trading is like throwing money around like confetti in an increasingly reckless manner. The brain is seeking to make sense of something that it can’t control, thereby creating the problems associated with compulsive gambling. After such episodes, traders, on reflection, will view such reckless activity as a moment of madness when the discipline and tools associated with risk management were abandoned. The potential for reckless trading starts once the emphasis in the thinking process shifts to reclaiming past losses, rather than the protection of the trading account. A successful trader will take a loss and practice patience whilst seeking to rebuild their bank by scalping small profits instead of seeking the big win.
When a big loss occurs the key is to enforce a stop to trading and take time out in order to return refreshed. This is made easier when having a positive self care regime and a solid social support structure that supports a healthy lifestyle. Traders who run into trouble often have a lifestyle that that is overly solitary and not balanced with positive and holistic counteracting activities.
4. Having an escalation of commitment to a losing trade
We like to be proved right. Who likes to admit, even to themselves, that the wrong decision was made? When a trade is not going in the right direction it is usually prudent to close it and accept a loss right away. Compounding a problem (such as widening a stop loss order) by buying more at a reduced price, in the hope that the price returns in your favour, usually spells disaster. It may happen occasionally but over the longer term it is not a profitable strategy. Successful traders will realise quickly that they are on the wrong side of a price movement and will generally be quick to acknowledge this and accept a loss. They will take a small loss on a losing trade and move on afresh to the next opportunity. Traders who display problem behaviour will continue to add their losing positions, a form of escalation of commitment, in the hope that the trade turns back in their favour. They find it difficult to change course as they are caught in the internal chatter of devil and angel and what to do. The devil can often appear to have the best tunes in such instances.
5. Allowing ego to take over in the search of a big win
The traders seeking to spot the next big short, or the next bull run, tend to be egotistical, as they are seeking to beat the big banks or to prove the media commentators or financial gurus wrong. Successful trading should not be so personal or so thrilling. You are not in a casino on a night out. You are seeking to dispassionately take advantage of opportunities presented in the markets rather than to prove a point against others. In any case, the big traders who successfully called a big short in the past rarely repeated their success in subsequent years.
Your objective in trading is to build your trading account slowly and consistently. In cricket terms your job is to keep the scorecard ticking over with ones and twos rather than seeking boundary scores with every hit. The big scores will come with the right ball not by reaching for a shot that isn’t there. This logic is similar to what the veteran investor Warren Buffett said about baseball “you don’t have to swing at everything, you can wait for your pitch.” For Buffett, the real problems encountered by money managers is the pressure from fans that keep yelling to swing. Traders face their own inner voices that fear an opportunity will be lost by not acting immediately.
6. Seeking perfect market timing
It is a huge misconception that volatile markets make it easier to make money. In reality volatile markets can also make it just as easy to lose money. Long term profitability is dependent on successful market entry and exit points, not on volatility per se. The key is to take profits when available and to green up your position as soon as possible.
7. Allowing emotion to overtake decision making
The old axiom that fear and greed tend to rule the markets can be very true. It is vital that you don’t allow emotion to negatively impact their decisions. Keeping abreast of news stories that will impact the market can prove to be useful but it is also the case that too much media monitoring can produce emotional driven trading. You need to adopt a professional mindset and not let emotion impact your decisions. Trading decisions that are based on emotions are a common reason why day traders end up producing negative returns.
You also do not want to watch your profit and loss statistics too regularly. A profit is only a profit when that trade is closed. Observing your trade go up and down with every tick as it happens is not a good idea. Your trading decisions are more likely to become vulnerable to emotion more easily if caught up in the emotional swing whilst watching your profit and loss account.
Undertaking mental trades, imagining what your winning or losing position would have been if the trades were placed, can create emotional mood swings when near misses have occurred. A near miss trade can, in effect, cause an emotional whiplash that can negatively impact on your emotional equilibrium when trading and lead to distorted thinking. You are not at the casino table. You are supposed to be level-headed and dispassionate in your trading decision making.
8. Not undertaking post trading analysis
The most successful traders will learn from their mistakes as well as their successes. Keeping records will help you to track your progress. Post trading analysis can help inform a trading check-list that is appropriate and relevant to you. Such activity can bolster your discipline and facilitate better preparation for your future trades.
9. Not staying aware of short term versus long term trades
Successful traders will stay aware of the distinction between the short and longer term vision for each trade. They will go long on a trade even in a market that they deem to be bloated from a valuation perspective, if they think that profit can nevertheless be obtained in the short term. Traders still make profits by trading in markets they believe to be in a bubble so long as they exercise the discipline to enter and exit the trades in a tight time frame.
10. Expecting to get rich quickly
The trading gurus helped create the illusion that with sufficient leverage, utilising the appropriate winning strategy and perhaps with some luck you can become rich very easily. Unfortunately, it is not as simple as this. Traders get into trouble when seduced by extreme forecasts. An example of this might be listening to Armageddon forecasts from media commentators and then being influenced to short when they would normally go long. Winning, no matter how small the winning trade is, creates a good feeling. You should seek this feeling and be content to win small every time you place trades.
Most traders will lose, especially taking account of the costs of spreads in trading. The get rich quick traders do not want to hear of the imperative to practice discipline and to rigorously prepare for each trading day, the need to test and continually try out new different ideas, regular calculating, monitoring and analysing data, operating a continuous self-improvement regime and journalling as part of their trading day. These things take time and are hard work. Above all a successful trading strategy requires professional adherence to a rigid and robust disciplinary framework that endures over the long term. Those seeking the casino high will flounder.
See also
When financial trading becomes problem gambling
Noel Bell is a UKCP accredited psychotherapist and can be contacted on (44) 07852407140 or noel@noelbell.net