Dear Fellow Trader.
This is a topic that is crucial and vitally important to trading.
It’s a Market of Emotions and 90% of all trading is based on psychology!
That’s a fact just like it is a fact that 90% of all traders who ever trade lose money and that 10% actually make a total loss going bankrupt. If the first number doesn't set off your alarm bells then the second definitely should.
But why is it then that such a large number of traders get driven by psychology and fail? Intelligent people with a high level of education watch their trading accounts erode taking one loss after the other.
So why do traders fail?
Without Education And an Understanding of The Psychology of The Market
Your Chances of Profitable Trading are Profoundly Limited!
While the trading instruments that make up the market have no emotions, the individuals that trade those instruments are human beings and are very emotional by nature. Realizing that the human emotions of fear and greed often drive prices up and down, allows one to begin to understand how to position oneself on the right side of the market. Because humans are very emotional, they often make rash decisions that end up being the wrong decision.
Every day there’s huge struggle being waged in the markets. A struggle between the bulls (buyers and the bears (sellers). Bears want to get top dollars for their equity, while the bulls want to pay as little as possible. In order for a transaction to be completed, one has to give into the other’s terms. If a greedy bull gives into a seller’s terms because he feels he just has to own XYZ stock, the price goes up. If an eager bear gives into a buyer’s terms, the price goes down. This is nothing new. It’s basic economics. It’s supply and demand.
Because both buyers and sellers are, more often than not, basing their buying and selling decisions on emotions, eventually these emotions will culminate and a trend will reverse. For example, when a stock is in an uptrend, there will be a point when the trend will become apparent to everyone. At this point there will often be one last buying frenzy as greed takes over in fear of missing the boat. It is precisely at this point that the trend will often reverse.
The same is true of a downtrend. Before a stock hits bottom, there usually is a panic-kind-of-selling as fear takes over and the weak run for cover. Once all the weak have thrown in the towel, the stock is free to rise again. This behaviour can be observed time and time again.
Often a stock doesn’t just drop because everyone starts selling. It begins to drop because everyone stops buying, at which point the price has to come down to entice more buyers. As the price begins to decline, the selling begins to pick up, forcing the price even lower. It isn’t until all the sellers are flushed out of the market that the selling stops. Now the demand for the stock becomes greater causing it to rise again and attracting more and more buyers.
If you have ever looked at a significant market bottom like the one after September 11, 2001 (9/11), you will notice that the selling pressure increased significantly due to the emotional insecurity of what might happen next. Once the selling became exhausted, prices stabalized and the crowd began to buy the market in droves.
Getting A Grip On Emotions
As individuals we have to realize and accept that we have no control and influence over the market nor the direction it’s taking. And thus, there are two crucial emotions that come into play and that we have to be aware of. Fear and Greed!
Fear:
The problem is that we all want to succeed and when we do make a loss, it is easy to let those losses effect us emotionally out of fear to lose even more.
In this case, a trader exits a trade as soon as the market hits the slightest bump even though the broad market is very bullish and the fundamentals of the company he’s trading are good. So instead of being patient and waiting for the trade to go up again, he sells and accepts the initial loss out of fear of losing even more.
Fear of losses can also show up in the following way.
Irrespective of any rationality, a trader holds on to a losing position for too long hoping for it to go up again. Even when the news and fundamentals are hopeless he won’t give up forgetting that this attitude can easily lead to a total loss.
In another case, fear can also manifest itself in not wanting to miss the boat and quickly jumping on. This can very often be observed by novices who listen to tips from friends and TV, where so called “experts” or shall I rather say, “opinion makers” speak up trying to sweet-talk you into a trade.
A trader sees the market go up rapidly and confirmation is all over the news. The excitement of a rising market is in full swing. Afraid of missing out, the trader makes a hasty decision and dives right into a trade.
Greed:
Becoming euphoric when you hit a winning trade is almost as detrimental as becoming depressed when you have a losing trade.
In this case a trader is actually afraid of losing a profit. He holds on to a winning position for too long. His trade is doing so well that he just can’t get enough. He may have made a 100% profit and now expects to make another 100%. And when his position goes down below this magic mark, he still holds on hoping for his trade to go back to 100% again before he sells instead of accepting say, 90%, which is darn good too!
But what was a 100% profit can easily become a total loss if you let greed take control!
I’ve seen traders that have watched their profits erode without doing anything about it. They held on to their positions right up to an almost total loss. Very often they then say: ”Oh well. my trade has gone down so much now, what’s the use of selling? I won’t get much out of it now anyway, so I might as well keep my position”. Well, I guess in a way he’s right because by this time his stocks may have more value being used as wall-paper.
In another case, fear of losing out on a profit may even cause a trader to sell a winning trade too soon. As soon as his position went up a few percent, he bails out.
So watch out for fear and greed. These two guys aren’t good advisers and they’re not the way to trade!
And so. As traders we have to be rather impartial.
We have to accept that there will be losses just as there will be wins in any one’s trading career!
Reaching the stage where you can comfortably accept losses, and knowing that you have a good trading system that will also produce profits most times in the longer term is the state we all have to aspire to.
Yours in Successful Trading
Ricky Schmidt
www.stockbreakthroughs.com