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What is Trading Psychology: The Single Most Critical Factor Between A Profitable and An Unsuccessful Trader

2022-06-22 10:09:18

Trading psychology is the study of emotions when trading–with a focus on controlling one’s emotions for better success. In fact, our state of mind influences everything we do, from working on a project to having a conversation, so it stands to reason that when performing a high-stress, and high-stakes, activity such as trading, a person’s state of mind is of paramount importance.

When to hold on for dear life (HODL)?

When to take the money and run?

These are questions that cannot be answered when one’s emotions are running high.

A stable and calm state of mind will help a trader execute his trading plan consistently. It will also help him recognize and respond to risks optimally by developing a well thought-out trading strategy without being overtaken by one’s emotions.

Trading psychology

Why Is Psychology So Important in Trading?

Humans are emotional beings, and despite the need to be analytical and cool-headed when trading, these emotions can get the better of us. Failure in trading can of course be attributed to the individual’s analytical skills, the trading tools at their disposal, and other factors.

However, trader psychology is considered one of the top reasons for failure. Studies show that up to 94% of traders fail to make money from trading because of psychological factors.

This emphasis on the psychology of trading is further highlighted by Dr. Van Tharp, a renowned professional trading and investing coach who categorizes the most important components in trading as follows:

  • Trading strategy (10%)
  • Money management (30%)
  • Trading psychology (60%)

With such importance placed on trading psychology, it is critical that we factor in the ability to control our emotions when trading.

Additionally, at the bottom of this article you will find a list of the best trading books on crypto as well as the best trading psychology books to help you learn about emotional trading and how to develop a solid trading psychology.

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How to Control Emotions When Trading

The biggest aspect of psychology in trading is emotional trading. Trading large sums (whether for a trading company or for yourself) is nerve-wracking—you could lose everything, make huge returns, or find yourself somewhere in between.

There are two key emotions to keep under control when managing expectations and maximizing one’s chances of trading success: fear and greed.

How do you avoid fear in trading?

Avoiding and controlling fear in trading are imperative as fear can make a trader sell prematurely, resulting in loss of earning opportunity or even worse, realized losses.

To avoid and control fear, a trader must first understand that fear in trading is a natural reaction when faced with a threat to profit potential. By understanding why fear occurs, a trader can put in place preventative measures to avoid it, or at least control it.

  1. Quantify the threat: By assessing the threat before starting a trade, you can be better prepared for fear. Work out what it is that you are afraid of and why you are afraid of it. For some people, the fear they feel may derive from the fact that they have over-invested or have plonked in money they cannot afford to lose.
  2. Make a plan: Once the threat has been identified, it is time to make a plan to avoid it or react to it if it happens. If you fall into the group of people mentioned above, you should reduce your investment down to a level you are comfortable with, hence limiting the fear factor.

Then, you should do your own research (DYOR), on both a macro and micro level, establish your limits for both loss and profit, and STICK TO THE PLAN. Promise yourself that you will not get greedy and or lose your head if the trade turns bearish.

Which brings us to our next point.

How to overcome greed in trading?

As important as it is to control fear, so is greed. Confidence tends to be in freeflow when your trade is looking very lucrative, but the truth is that trading is high-risk and highly volatile, meaning it could turn the other direction very quickly, as many new traders are starting to find out in the current crypto climate!

Traders are often reminded that money can be made on bullish and bearish markets, but that greed leads to loss, as the saying goes: “Bulls make money, bears make money, pigs get slaughtered.”

To avoid and control greed, a trader must first recognize when they are being greedy. It may be harder to prepare for than fear, but the basics still apply.

  1. Quantify the greed: Every trader is looking to make money, so it is only natural that you look to maximize profits. However, there are good and bad ways to do this. First, recognize if a part of you is focusing too much on the profit and not enough on the strategy. In other words, how realistic is your profit expectation? And what will you do if things do not turn out your way?
    The irony in trading is that you will make more money in the long term if you learn to manage risk, while if you assume high degrees of risk or completely overlook risk, you may maximize short-term gains, but it will not last. Greed will push you to take on risks that will one day get the better of you.
  2. Make a plan: Do your research to remind yourself of how quickly a market can turn. Then, assess your trade to ascertain a safe and reasonable level of profit. Once you have established your target profit, set your trading strategy based on a realistic risk-to-reward ratio. When you have made the profit you set out to make, exit the trade gracefully and go on to your next profitable trade, and so on.

In crypto trading especially, greed manifests as the FOMO monster who usually sounds like this, “What if you sell now and the coin goes to the moon?”

Well, now you know better and can reply, “What if I don’t sell now and it goes to zero? Better something than nothing!”

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How to Develop and Improve Trading Psychology

Improving and developing a healthy psychology of trading is all about experience, self-reflection and humility. As with learning anything new, you will go through the process of knowing nothing, thinking you know everything, realizing you know nothing, then finally learning, and getting to know something.

This is called the five stages of trading psychology.

It is important for any trader to understand these stages, but even more important is identifying which stage you are at. This will help you identify your blind spots and risks that you are taking on unknowingly.

The Five Stages of Trading Psychology

#1 Unconscious incompetence

This first stage is where most novice traders are forced to exit the trading markets.

They are usually enticed by the high returns that investors make in various media outlets and convince themselves that they too could start trading and buy a Ferrari the next month, if not week.

This is similar to how teenagers see celebrities on screen and assume that they too can be wealthy and famous. What they don’t realize is that those who make it are the exception.

They will open a few trades, have a degree of success that spurs them to open a live trading account, and invariably lose all their money. They jumped in not knowing that they knew nothing about trading.

#2 Conscious incompetence

The second stage is where those who have recognized that they know nothing, come back to the table and are prepared to put in the work to learn.

At this stage, the novice trader will buy all the best trading books and trading psychology books, listen to podcasts and YouTubers, and maybe even consult some professional coaches. He will try again.

By studying various trading tools and indicators the trader will have some successes and failures, but most will not make much money and will eventually give up after some months or even years.

#3 The “Aha!” moment

This is the breakthrough point, where the trader, with his new knowledge and experience finally leads him to the realization that trading is not a sure science and that he does not need to utilize every tool or consult every indicator to make a trade, and that there is no single expert who can accurately predict the market.

Here is where the trader, no longer a novice, will recognize that he will lose some and win some. He realizes that the trick is to manage one’s emotions and limit one’s risks to the level that he is comfortable with.

#4 Unconscious competence

Armed with the above realization, knowledge, and experience, the trader will start to carry out trades differently. He will be patient, not ape-ing into every coin, taking on unnecessarily risky trades and giving in to the FOMO monster.

Instead, he enters his trades more prepared to handle whichever way the market goes. This is the stage where, although still incurring some losses here and there, the trader will make fairly consistent wins. This stage usually lasts around 6 months, but most traders never make it this far.

#5 Conscious competence

This is the level where the trader stands a chance of joining those he read about in the media in stage 1. At this point, he will still make some losses, but they will be mitigated by the wins. He will have mastery over fear and greed, he will know both the art and science of reading the market, as well as how to set up his trades, and when to make a rewarding exit.

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Must Read Books for Day Traders: Best Trading Books and Trading Psychology Books

As promised, here is a short list of some of the best trading books focusing on crypto, as well as the best trading psychology books on the market today. It should be noted that this is not a comprehensive list and, as mentioned in the five stages of trading psychology, merely reading these books will not guarantee that you will make it into the Forbes list overnight, but hey it’s all about progress, not perfection, right?

Best trading psychology books

  • Trading in the Zone by Mark Douglas
  • Sway: The Irresistible Pull of Irrational Behavior by Ori Rafman and Brom Rafman
  • The Art of Thinking Clearly by Rolf Dobelli

Best trading books for learning and understanding crypto

  • Cryptoassets: The Innovative Investor’s Guide by Chris Burniske and Jack Tatar
  • Mastering Bitcoin: Programming the Open Blockchain by Andreas M. Antonopoulos
  • Blockchain Bubble or Revolution: The Present and Future of Blockchain and Cryptocurrencies by Neel Mehta, Aditya Agashe, et al.

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