The concept of Psychology in the markets can be broken in 2 broad ideas - Trader Psychology and Market Psychology (or Sentiment).
There is an oft quoted statistic that 80 percent of traders fail. They lose money Ć¢ā¬ā 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.
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, a trading coach for over 18 years, says the following in his excellent book, "Trading in the Zone" .
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).
What this essentially boils down to, is that if you can't remove that emotional attachment - be it to the money itself, or the fact that there are going to be a few losing trades along the way (quite possiblity a string of them at some point), you may struggle to become successful.
Douglas incorporates some interesting ideas within "Trading In The Zone", ideas and thoughts that many of us have no doubt had at some point or another. Here are a few:
"Think about the number of times you've looked at a price chart, and said to yourself "Hmm, it looks like the market is going up (or down, as the case may be)," and what you thought was going to happen actually happened. But you did nothing except watch the market move while you anguished over all the money you could have made"
Douglas says - rightly so, that "there is a big difference between predicting something will happen in the market and the reality of actually getting into and out of trades". Similar results can be seen when 'paper trading'. Oft it is quoted that someone has done particularly well on a broker's simulation platform, and then seen their capital slide away when they have started trading for real. Surely, there are only three reasons that can cause this (if we discount the 'rigged broker platform' scenario).
The first one is that the strategy being used changed, and this had a disastrous effect on results. Possible, but unlikely given that it was a winning strategy "on paper".
Second is that the markets changed. Again, this is not impossible - markets go through phases where they can be easier to trade than at other times, so our hypothetical trader could simply have started trading real money at an unfortunate time.
Third - and the most likely scenario - is that once the trade actually became worth something, the trader had trouble managing the trades as well as he did when they were paper profits. Think about it. When the results are on paper, if a trade turns against you as soon as you're in it... who cares? You wouldn't have taken that trade in real life, anyway... would you? But when that's a real trade, and it moves against you as soon as you're in, racing towards your technical stop, who isn't going to think "Gee, this looks like it's going to trigger my stop - I'll get out now and save myself some money". But of course it doesn't trigger the stop, it misses it by a pip or two. Or maybe it does trigger the stop - but only because you tried to convince yourself that your stop point was the right stop point - even though, technically, it may have been slightly too tight. Anyway, the end result is that had it been on paper, you wouldn't have cared, and it might have come back in your favour. But you'll never know, because you pulled the plug on it, rather than watch your money dissapear into someone else's pockets. So, what was a winning strategy on paper becomes a losing one in real life because the trade cannot be managed effectively, due to the emotional attachement and the psychological issues surrounding it.
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.
Staying with Mark Douglas, he manages to seperate the winners from the losers by looking at their attitude to trading. Specifically, that the winning traders "have a mindset which allows them to remain discliplined, focused ... and confident despite of adverse conditions". This set of attitudes allows them to step aside from the fears and errors that other traders have. These attitudes are their discliplines, pure and simple. To these traders, trading is as automatic as taking a breath.
No trade has a guaranteed outcome, of that much we can be certain. There are no guaranteed wins in the markets, the biggest gambling arena on the planet.
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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