Psychology of Trading
Responding to Losing Trades
New traders are concerned only with making money. They celebrate when their trades are profitable and ignore trades that lose money. This is a bad idea. The path to becoming a long-term successful trader requires an understanding why the trades lost money. Then it becomes possible to reduce the number of trades that failed. In other words, if you buy call or put options, only to see them expire worthless, then you should fare better by finding other strategies -- other than buying options.
We all make winning and losing trades -- just because of probability. Some, but few, traders are skilled at predicting market direction. However, most traders -- including professional money managers -- have a difficult time outperforming the market averages. Studies have shown that most individual investors fail to understand this simple principle and tend to believe that their results are better than their actual results. In other words, they believe they do better than the market averages, when in fact, they perform far worse.
If we have no special skills when selecting our trades, then we must develop some skills that give us a trading edge. With no edge, we can expect to win about half the time. When we add in the cost of trading (i.e., commissions) we must do one of two things as traders:
Earn a profit well over 50% of the time
Be certain that we do not lose more money from losing trades than we earn from winning trades.
To meet that goal, we must practice good risk management and be certain that our losses are limited to acceptable levels. However, that is not the only thing we can do to achieve success as a trader. The way we think -- the trader mindset -- contributes a great deal to the success or failure of almost every trader.
The Trader Mindset or the Psychology of Trading
I recommend reading the work of Dr. Brett Steenbarger for insight into the psychology of trading. The following are his thoughts on how traders respond to losing money:
"When I first worked with traders in financial markets on a full-time basis, I was struck by how they responded to losses in their trading. Three groups stood out:
1) The first group kept trading after losing, often by increasing their risk-taking. They were clearly frustrated with their losses and driven to get the money back. They absolutely refused to quit. They took losing money as a kind of affront and redoubled their trading efforts.
2) The second group was also frustrated with their losses but was determined to not allow those losses to pile up. They took breaks in their trading, calmed themselves down, and often stopped trading for the remainder of the day. Their goals were to regain emotional equilibrium and not let frustration drive their decision making.
3) The third group was also quite frustrated with losses, but those traders stayed at their desks and they stopped trading. Instead, they doggedly tracked down the sources of their poor trading and did not stop in their analyses until they figured out where they had erred.
Only then did they return to trading.
Over time, distinct differences in outcomes became evident among the three groups. The first group was most prone to blow up, as they doubled down on risk-taking precisely at the times they were trading their worst. Frustration, for them, led to reactive and often destructive decision making.
The second group never blew up, but rarely excelled. Their focus on not losing money kept them emotionally controlled but did little to help them learn from their setbacks. In other words, they succeeded at coping but not at developing as traders.
It was the third group that, over time, proved to be the most successful. They were every bit as frustrated as the first two groups, but they channeled their frustration toward betterment. They operated with a growth mindset.
They stayed engaged in their work, but constructively. It wasn’t so much that they had mastered markets; rather, they mastered the process of turning setbacks into learning successes."
And that is the key. When traders work on developing specific skills, they can succeed. For example:
- For the Option Trader. Find strategies that you understand well. Use them when you believe market conditions are appropriate (i.e., covered call writing and naked put selling work well in a slightly bullish environment; iron condors work well when market volatility has been high but is steadily decreasing). Track the results. Figure out how well the market environment that you anticipated became reality. Over time, you will discover which strategies work well - not only because the strategy itself was viable - but more importantly because you adopted it at the right time. Develop the discipline to take those inevitable losses; know when enough is enough and exit winning trades when the remaining potential profit has become too small to justify the risk of earning the last few nickels on a trade.
- For the Technical Analyst. Learn chart reading. This takes time and is never something you can learn overnight. Even though there is no guarantee of success, any edge helps. If you get a buy signal, then it is okay to get long -- even when you know the signal may be wrong. But your success comes from cutting losses and from studying all the signals. Learn which ones work often and which are no better than break even. Study the results and gain an additional edge by knowing which ones work for you.
- For everyone: Do not trade just to trade. When your results are poor, take a break from trading, but not from analyzing your results. When your strategies do not work, carefully figure out whether it is time to sit on the sidelines or adopt another strategy. but do not just guess at what to do. Have a sound reason for every trade.