The brain game: how trading psychology can work for you (2024)

Trading psychology is about understanding and being aware of your emotional reactions. Two people might have completely contrasting reactions, and so approach the same situation with a different attitude. That’s why it is important to know how to manage your emotions when you’re investing.

Despite the importance of psychology, everybody spends their time on strategy. If they switched their focus, many traders would find they became a lot more successful.

The emotional rollercoaster of trading is just like a price chart. You’re up and then you’re down. This becomes heightened in the volatile markets we have experienced over the past few months, which are being driven by the US Federal Reserve’s plans for multiple interest rate hikes and, more acutely, by the situation in Ukraine.

In volatile markets, everything is accentuated. Big daily and intra-day swings heighten the fear and heighten the greed – the two emotions that often dominate trading decisions. At times like this, it is important to remember that if you want to take the same level of risk, your positions (on each trade) need to be a lot smaller.

Last year was characterised by low volatility, which leads to complacency. In that situation, equities are going steadily up and new traders, in particular, are likely to get a sequence of winners. They then begin to think it’s easy. They get overconfident, overestimating their skills, and end uptaking uncalculated risks where they don’t necessarily understand what is at stake.

Now we have moved into a world of high volatility and that overconfidence can really cost a trader. It is not about removing all emotion. People used to be told to leave their emotion at the door, don’t have any feelings. But actually, neuroscience teaches us that you can’t make the best decisions unless you accept the feelings.

One key piece of advice is to avoid focusing on profits. It’s a bit like if you are trying to lose weight: you shouldn’t focus on the weight you want to lose, but on the calories you take in. Profit and loss is a vanity metric. Instead, you should focus on something you can actually control. Trading psychology is one of those things.

Emotion when trading can be a real advantage if used properly. It’s the awareness that counts. Some of the highest profile and most successful hedge fund managers are incredibly emotional. But even the most emotional traders in the world, with awareness, understand how to manage themselves.

One simple measure we examine at City Index is known as “disposition”. This is a term for how much time you spend on a winning trade compared with a losing trade, and analysing it can reveal a lot about your psychology. The human reaction when you start to make a bit of money on a trade is to protect that win. Many people will get very cautious and close the trade because of the winning position.

In the opposite situation, if you’re losing money from a trade, it is often instinctive to become risk-seeking as you attempt to recover the loss. That means many traders have small winners and big losers. They may still be winning 80 per cent of the time, but they’re not making money because the losses they have are out of proportion. Some people are spending only 5 per cent of their time on winners, and the rest on losers. That’s trading psychology in a nutshell.

It is important to remember that weare not symmetrical in how we react to a win and a loss. Most people will have a greater reaction to a loss than to a win. We will take a win as a positive, but a loss can count double. That means you need two wins for every loss to be balanced psychologically.

Balance is important but, when you trade, you are never balanced. Even if you win 50 per cent of the time, the winners often aren’t big enough and you have all of this negative emotion. But if you know that, if you have the awareness, you can learn to use that feeling to your advantage.

Even when you are managing your emotions and have a strong trading plan in place, things can go wrong. You can win when you do everything wrong and you can lose when you do everything right. The psychology comes in when you understand that.

At City Index, we work with Premiership Rugby club Saracens. Those guys are brilliant when it comes to understanding trends in the data and sticking to a plan to achieve their goals. They look at their metrics and understand over time what they are able to achieve. Sometimes they may decide it’s been a bad day – but they don’t change the way they play.

The same goes for trading. If you understand your own psychology, youwill always have a better chance ofachieving your goals.

For more information visit cityindex.co.uk