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Psychology

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The concept of Psychology in the markets can be broken in 2 broad ideas - Trader Psychology and Market Psychology (or Sentiment).


Contents

Trader Psychology

There is an oft quoted statistic that 80 percent of traders fail. They lose money – they either retire or go broke. It is not that they make a lot of mistakes. It's all in the mind.

Successful traders always acknowledge the importance of psychology in their trading. Traders must be disciplined and remain emotionally detached from the markets.

Trading requires management of the emotional states. Emotional imbalance impairs the ability to make congruent decisions. The most optimal state is one of complete emotional detachment, to remain calm and to act in accordance with your strategy. That includes negative as much as positive emotions - the key word is to stay "cool".

Your psychological mind set may play a larger role in your trading career than your chosen technique or any other details associated with your day-to-day practice. Indeed, discipline is just one attribute of trading psychology, but it just so happens to be the most important psychological factor that affects a trader's success.

It doesn't matter whether you trade stocks, indices, commodities, futures or any tradeable instrument, the most importnat part of the trading game is your own mind.

The Nature of Trading

Traders forecast future price using some combination of fundamentals, indicators, patterns and experience in the expectation that recent price patterns forecast the probable future often enough to make a profit. The trader's problem is that nothing that has happened in the past or that is shown on his indicators is any guarantee that future prices will go in the direction and amount needed for a profit. The profitability of each trade has some randomness and uncertainty. This is a realm that many are not equipped to deal with. We do not know what to expect from random processes and are not innately equipped to deal with the psychology of trading. Trading is not a sure thing. It is a probability exercise. Traders talk about having an edge, which is simply a higher probability of one outcome than of another. To succeed you need probability on your side. You need an edge. Mark Douglas in his excellent book "Trading in the Zone" says the following.

There is a random distribution between wins and losses for any given set of variables that define an edge. In other words, based on the past performance of your edge, you may know that out of the next 20 trades, 12 will be winners and 8 will be losers. What you don't know is the sequence of wins and losses or how much money the market is going to make available on the winning trades. This truth makes trading a probability or numbers game. When you really believe that trading is simply a probability game, concepts like "right and wrong" or "win and lose" no longer have the same significance. As a result, your expectations will be in harmony with the possibilities.

(Mark Douglas: "Trading in the Zone: Master the Market with Confidence, Discipline and a Winning Attitude." New York Institute of Finance: New York, pp 130-131).


Steps to Success

Self-discipline is the mental technique needed to stay focused on what you need to learn or do to achieve your trading goals.


Market Psychology

The feeling or tone of a market (i.e. crowd psychology) is shown by the activity and price movement of the securities. For example, rising prices would indicate a bullish market sentiment. A bearish market sentiment would be indicated by falling prices.

Charles Mackay's famous book, "Extraordinary Popular Delusions and the Madness of Crowds", is perhaps the most often cited in discussions of market phenomena, from the tulip mania in 17th-century Holland to most every bubble since. The story is a familiar one: an enduring bull market in some commodity, currency or equity leads the general public to believe the trend cannot end.

The key to such widespread phenomena lies in the nature of the crowd: the way in which a collection of usually calm, rational individuals can be overwhelmed by such emotion when it appears their peers are behaving in a certain universal manner. Those who study human behavior have repeatedly found that the fear of missing an opportunity for profits is a more enduring motivator than the fear of losing one's life savings. At its fundamental level, this fear of being left out or failing when your friends, relatives and neighbors seem to be making a killing, drives the overwhelming power of the crowd.

The Psychology of Price Movement

A trader's reaction to price movement effects traders in every market situation.Traders all react to changing market prices, but in a different manner. Chart formations generally result in predictable market action because of the predictable psychology of the traders in that market pattern. Fear, greed and frustration all manifest themselves in pattern movement.

The effect our emotions have on price movement can be seen in the changing psychology of the market.

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