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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|
Most people use some form of technology to assist in their trading. You may follow a particular person’s analysis or recommendations, you might track special charting systems, or perhaps you take a more detailed approach to the fundamentals underlying a particular market.
As useful as all of these technical analysis tools are, it is important that you remember that they are only tools, and that too much reliance on them can take away from, rather than add to, your trading success. Trading blindly on the recommendations of any software or analysis tool can often be a recipe for disaster.
When using technology (such as charting software or other analysis tools), it is important that you understand the underlying concepts and the reasons behind what the charts are telling you. This will allow you to see the bigger picture and avoid unnecessary mistakes.
Timing mistakes are common among people new to trading. Inexperienced traders will often miss out on the full potential profit of an idea because they act at an inopportune time.
Timing is not an exact science, but there are certain times and situations that you can learn to identify and recognise as more prudent than others.
Ultimately, however, the best way to learn about timing is through experience.
A detailed record of your trading can have many benefits. It can show where you went right in the past, and where you went wrong. Yet most traders fail to take advantage of these learning opportunities.
Consider the value of being able to look back at previous experiences, having noted what happened in the market, what trades you placed, what your profit/loss was, and even how you felt about placing and coming out of the trade.
A trading log or diary can be an immensely powerful tool, and it is one of the most common and costly mistakes to neglect it.
A trade’s risk v reward ratio is the relationship between what you stand to lose and what you stand to gain. To calculate this ratio you need to know the current price of the instrument, your profit objective and a stop exit price.
You can know all these things before you trade, and so you can establish whether the risk v reward ratio of your trade falls within your trading strategy. See our managing risk module to learn how to calculate your risk v reward ratio.
Novice traders should stick to ratios with low risks and high rewards, to minimise the potential for large losses. More experienced traders, on the other hand, might prefer to take on more risk in pursuit of greater reward.
Whatever your appetite you should be aware of the risk v reward ratio on every trade so you always know where you stand.
Creating a trading plan is important, but it’s not worth anything if you constantly deviate from the course you have plotted for yourself.
You may be tempted, every day, to ignore your trading plan and just stay in a little longer on this trade, or go in heavy on that one. But if you really take the time to develop your trading plan then you should have faith in it being the best-suited approach for you.
Even the best trading plan remains only a guide, but the better the guide, and the better you can stick to it, the better success you will have in the long run.
One of the most dangerous trading misconceptions is that you can ride out any storm and turn running losses into profit.
Knowing when to stop is an important skill to develop, and it is an ability that comes mostly through experience. But there are techniques that you can use to guard against keeping losing positions open too long.
Keep a trading log of previous trades. This will give you a good indication of when you came out of losing positions before, or when you didn't.
Naturally, there may be situations when you have to endure manageable running losses to emerge in profit in the long-term, and recognising these situations is one of the skills you’ll develop as you gain experience of trading the financial markets.
Any time you make a significant profit on a trade, of course you’ll feel delighted and even euphoric. It’s important to be aware that this can affect your perceptions of the market and influence your actions, especially regarding future positions. There is always the risk after some success that you may rush into a new position that is not as favourable, just on the back of enthusiasm and high morale.
Remember, there’s no such thing as a ‘winning streak’. Just because you’ve had a few successes, that doesn’t mean you’re destined to profit in whatever you do. Only a good trading strategy will help you to sustain your profitability over the longer term.
Immediately after a win is an important time to sit back and consider your trading strategy closely. Any new positions you open at this time should be in line with your overall trading plan, not just feel like a good idea while you’re still on your winning high.