The market influences a trader’s psychology to the same degree that investor behavior influences the market. However, traders often underestimate the role of trading psychology on their trading success. Discussions on the topic tend to be few and far between with just a bunch of vague advice floating around on the internet. Many advocate trading like a robot to be the most effective way to succeed.
However, those who are discretionary traders should get to know their mental states and emotions in general, looking to use them to their advantage. Contrary to popular belief, emotions are not something to be suppressed while trading. Developing a framework and a coherent definition of a trader’s psychology is thus essential for a trader before they embark on their trading.
How to Create a Framework
Creating a rough framework is essential for identifying which parts of a trader’s practices are most affected by trading psychology. Even though one’s psychology affects virtually all components of trading, there are a few which a trader should focus on more.
- Swings and Streaks
- Execution: Entry and Exit
- Trade Management
Swings and Streaks
Many developing traders have a common misconception about streaks, where they believe that they should size down when in a winning streak to cool off or size up when in a losing streak. However, sizing up is not always the best option and may have some unintended consequences, to say the least as some strategies do not scale upwards correctly. The execution troubles could increase if one invests more.
For instance, the first trade that a trader decides to size up ends up losing. This can result in an utter lack of confidence, and the trader can miss the next trading opportunity. They can also make the mistake of jumping into a “not- so- good” trading opportunity. Traders facing such situations should trade more setups using several timeframes across different markets, keeping their bets as they were before.
When it comes to sizing down, most traders look to trade less when on a losing streak rather than sizing down. However, for a more conservative approach, traders should usually cut their size by half if they’re on a losing streak lasting more than three consecutive losing trades. The losing streak can be a sign that the market conditions have drastically changed.
Equity curves do not fly up vertically but rather trend up. When a trader starts taking hits, sizing down will flatten things out at best. However, they should set a higher low when the losing streak ends.
Execution: Entry and Exit
Many traders conflate trading with technical analysis. However, struggling during trade execution can be seen as a byproduct of conducting too much technical analysis and a lot less trading. To address the problem of execution, we should take a look at this from two aspects—sizing and Entry checklists.
- Sizing – The high degree of risk is one of the biggest potential reasons for execution fears, whether it’s in absolute terms or relative terms. If traders are too scared to execute their plans, they can simply take off some risk. This is possible by smaller sizing. Any of the following ways can achieve smaller sizing:
- Downscaling risk per trade
- Scaling into positions
- Splitting up one’s clips up and adding a remainder upon confirmation.
Risking only 1% or 2% of a trader’s account rather than 10% can help traders to get more involved in the market and also be less affected when the market turns south.
- Entry Checklists: Traders should maintain a checklist of conditions that trade needs to satisfy before the trader takes it. This is called an entry checklist. There are no “one size fits all” checklists available. Traders should look to develop their own lists based on their trading style and system. If a trader frequently fails to execute trading opportunities based on the list, the trader should reduce its scope. An entry checklist that forces traders to execute trades early should be modified and improved at once.
Trade Management encompasses a set of decisions that a trader makes between opening and fully closing a position. There are two main facets of how to trade management is affected by trading psychology, namely, general trade management planning and PnL based trade management.
- General Trade Management Planning: One of the benefits of making a plan is that a trader is objective while he makes it, with no money on the line or no swing profit or loss. The gap between real trading and technical analysis is most exacerbated in this area.
- PnL-Based Trade Management: Trading without profit and loss figures on the screen is a recommended move. Decisions should be per the trader’s trading style as well as the market instead of profit and loss considerations. Some common PnL related bad decisions include closing winning trades early and holding trades over pre-determined take profit areas.
Traders need to note down their feelings and emotions in their trading journal while trading. This includes observing the emotional response once they trigger a trade, how they feel about management decisions made, and what their mental state is once the trade is complete. It becomes an invaluable resource to check if one goes through a rough patch and wants to find out what went wrong.