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Understanding Trading Psychology & How To Overcome It

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  • Digital Team 

To be a successful trader, you don’t just need technical expertise and market knowledge – you also need to understand trading psychology. It can have a huge impact on the trading decisions you make, and greatly reduce your chances of profitability. 

In this article, we’re going to explore the definition of trading psychology, the different types of biases traders experience, and some methods for mitigating them. 

What Is Trading Psychology?

Trading psychology is the attempt to understand the emotional and psychological elements that influence the decisions traders make. In all aspects of life, our psychological and emotional states have a big impact on our performance and behaviors, and trading in financial markets is no different. 

Whether you trade options online or buy and sell crypto, your cognitive biases, emotions, discipline, and self-control are all contributing factors to your trading outcomes. 

Trading psychology is important as it focuses on the necessity of risk management, self-awareness, discipline, emotional regulation, and resilience for traders. This can help them to make more consistent, objective, and successful trading decisions. 

If you’re a trader, overcoming the psychological barriers involved in trading could be the key to achieving long-term profitability. 

Cognitive And Emotional Biases In Traders

There are two types of biases you need to understand to get to grips with the idea of trading psychology. These are cognitive bias and emotional bias. Let’s take a closer look at each one. 

Cognitive Bias

When you have a cognitive bias, it means you systematically deviate from rationality when you’re making certain decisions. Essentially, your brain takes shortcuts which can lead to irrational judgements and decisions.  Cognitive biases are often the results of:

  • Brainpower limits
  • Being swayed by social influence
  • Your individual experiences

It’s an issue because it can affect your memory, perception, problem-solving, and attention – which are all vital for making optimal trading decisions. 

Emotional Bias

Emotional bias refers to the ways in which your feelings and moods can influence how you make decisions. Some common emotions people experience when trading are excitement, greed, and fear which can all result in emotional biases. 

These biases can make you more impulsive and negatively affect the way you perceive risk and reward. This could lead you to enter into trades that are far riskier than ones you’d usually get involved with. 

You must be aware of both types of biases so that you can learn to mitigate them and become a more successful trader. 

Types Of Cognitive Bias In Traders

Some of the most common types of cognitive biases that traders experience include: 

Illusion of Control Bias

This is when you think that you have far more control over the outcome of a trade than you do. You may start to have too much belief in your ability to foresee or directly influence moves in the market. This can lead to exaggerated levels of confidence which can result in warning signs being missed and too much risk being taken on. 

Confirmation Bias

This bias is common in everyday life so it’s no surprise that it’s also regularly experienced by traders. It involves favoring information that confirms beliefs you already hold or interpreting it to support your theories. 

It can be incredibly detrimental to your trading performance as you’re likely to ignore evidence that suggests your notions are wrong and make decisions based on poor information. 

Availability Bias

This is the tendency to rely on recent trading experiences or information that is easily available when making decisions. This means you might miss out on other data that’s less accessible but that could’ve given you a more comprehensive understanding of the market.

Hindsight Bias

Hindsight bias involves looking back on past events and believing they were more predictable than you thought they were at the time. This may sound harmless, but it can impact your future decision-making if it fills you with unwarranted confidence in your ability to predict market events. 

Anchoring & Adjustment Bias

This is when you take an initial piece of information (an anchor) and base all of your subsequent trading decisions around it. Even when new information or data emerges, you fail to adjust your approach enough and remain attached to the anchor. 

For example, the anchor could be an initial valuation or price you received as part of a trade. 

This bias limits your ability to adapt and adjust to new developments and gives you less chance of making successful trades. 

Types Of Emotional Bias In Traders

There are plenty of types of emotional bias that traders frequently experience, such as:

Self-Control Bias

This is when you struggle to base your decisions on your long-term trading goals and strategy and base them on impulses or short-term market fluctuations. Essentially, you fail to control yourself from taking actions that may cause long-lasting damage. 

Overconfidence Bias

As the name suggests, this is when you place too much confidence in your own trading abilities. It leads you to think you have more knowledge of the markets than you actually do, and that your predictions will be accurate as a result. 

It often leads to taking excessive risks, ignoring your risk management strategies, and overtrading. 

Loss Aversion Bias

Put simply, loss aversion bias is when you prefer to avoid losing over making gains. If you’re more focused on potential losses than potential gains, your behavior may become overly risk-averse. This can make you reluctant to cut your losses when necessary and can cause you to hold onto losing positions for too long. 

Regret Aversion Bias

This bias leads you to avoid actions that could make you feel regret, even when taking those actions is the right decision. It’s similar to loss aversion bias and might make you avoid cutting your losses when you should because you think you’ll regret it later. 

Status Quo Bias

This is a reluctance to adjust and change your portfolios and strategies because you favor familiar positions. Even when it’s the right time to make a change, you resist and stick to what you know. 

How To Gain Control Of Your Trading Psychology

Many of the common mistakes traders make are a result of emotional or cognitive biases, and overcoming or mitigating them is vital. Although it can be difficult, there are steps you can take to achieve this. 

How To Mitigate Emotional Biases

  • Develop self-awareness: Be reflective about your patterns of behavior and your emotional tendencies. Identify decisions that were affected by your emotions and be aware of exactly what emotions influenced you at the time. 
  • Set clear goals: Establish goals that are specific and realistic. When your objectives are clearly defined, you’re less likely to make impulsive decisions driven by emotions. 
  • Create a trading plan: Develop a plan that includes risk tolerance, entry/exit points, and profit targets. This should help to keep you focused during volatile market conditions. 
  • Use stop-loss orders: This automatically triggers a sale when a predetermined price level is reached. It can help to prevent emotional reactions to market fluctuations. 
  • Practice patience: Don’t allow yourself to succumb to Fear of Missing Out (FOMO). Be patient and focus on your goals when making decisions. 
  • Utilize automation: Where possible, use automated trading platforms to remove the need for your input into certain trades. This eradicates any emotions from the process. 
  • Manage stress: Trading can be pretty stressful so ensure you take regular breaks and try to keep your stress levels down. This can help you to make more rational decisions. 

How To Overcome Cognitive Biases

  • Diversify information sources: Avoid one-sided perspectives by seeking out information from various sources. This is a great way to overcome confirmation bias. 
  • Use data and analytics: Utilize data-driven analysis and quantitative metrics when making decisions, as they provide you with objectivity. 
  • Challenge your own assumptions: Consistently question your assumptions and look for information that contradicts your beliefs. If you come across new evidence, be open to adjusting your views. 
  • Create decision-making checklists: Make structured checklists that help you consider all relevant factors before you make a decision. This can reduce the chance of impulsive decisions caused by cognitive biases. 
  • Find a mentor: A trading mentor is someone you can share your ideas with and who gives you honest feedback about your viewpoints. They can act as a check against your cognitive biases. 
  • Review past decisions: Look back on your past trading decisions regularly. Analyze unsuccessful and successful trades to identify patterns of cognitive bias. 
  • Use trading simulations: Simulating trading scenarios is a great way to practice your trading skills without the risk of financial consequences. It can help you to identify your cognitive biases in a safe environment. 

Final Thoughts 

As a trader, recognizing and addressing your cognitive and emotional biases is a key element of making objective, informed decisions. Although it’s tricky, you can mitigate and overcome these biases using the methods in this guide. If you manage to do so, you’ll increase your likelihood of trading success and sustained profitability.

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