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Psychology is a key element of financial trading, and how you perceive and react to your trading can have a major impact on your success. In this module we go through some elements of trading psychology and identify a few common mistakes to watch out for.
|Trading psychology||Before you trade||Trading mistakes||Technical mistakes|
|IntroductionEmotionsSentimental tradingPatienceStaying calmBeing decisive||Being unpreparedAssuming easy profits||Over-reliance on softwareBad timingLack of record keepingNot calculating Risk v Reward ratioDeviating from the planNot cutting your lossesOver-reacting to wins||Limiting your optionsOver-diversificationOverexposureUnnecessary risksTrend misconceptions|
The world of financial trading is vast. There is a seemingly endless range of markets that you can trade on, including shares, forex and commodities, and an equally immense suite of products to enjoy.
There is always the risk of overexposure, and you should never open trades just for the sake of it, but if you disregard trading alternatives you may limit your profit opportunities.
For example, a common mistake is to think you can only trade on an asset that you expect will increase in value (going long). Too many people completely ignore the fact that you can back an asset to decrease in value (going short) just as easily in most cases.
Disregarding the opportunity to go short is a severe limitation on your trading. You can learn about going short in our short-selling module.
The degree to which you expose yourself to various markets is a decision you have to come to based on your knowledge and experience levels.
One strong word of warning, however, is that you should try and stick to the markets and products you understand well, rather than be tempted by opportunities that are unfamiliar to you.
You may think it is prudent to diversify your interests, perhaps to hedge your trades or keep your overall portfolio safe. There is merit in this approach, but only so far as you trade what you know. Trading merely for the sake of diversification can quickly open you up to error.
There may be times when all you can see is opportunity, and it can be tempting to invest all your capital in what you may think are profitable positions. However, there are severe risks involved with being overexposed in these situations.
Without the benefit of a crystal ball, we can all be taken by surprise by a sudden, unexpected event that rapidly sends a market in the opposite direction. Even when you’ve taken steps to limit your risk, you can still suffer substantial losses if you have a large sum invested.
This is especially true if you are trading leveraged products, as you always run the risk that you might lose more than your initial investment.
This one should be obvious. Considered risk is a part of trading, and you should be thinking about it on every trade by assessing the risk v reward ratio. But it is important that you maintain perspective and can identify which risks are part of your plan and which are unnecessary and possibly even foolish.
Some straightforward examples would be to go short on a bull market, or to buy when the trend is bearish. There are always exceptions to the rules, and these can seem very tempting, so just make sure you always know where reasonable risk ends and where unnecessary risk begins.
A trend generally concerns the long-term direction taken by a market, and is based more upon macro-economic influences than one-off events. Individual political or economic events seldom drive trends in their own right.
So, while worse-than-expected non-farm payrolls, for example, may cause the Dow Jones to drop as an immediate result, this doesn’t necessarily mean the overall trend of the index will change from positive to negative.
There is an abundance of software available to analyse market trends, and these tools can be valuable if used correctly. You should just be careful to distinguish between short-term and long-term influences, as these are not necessarily always aligned.