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Chapter 7 Overcoming Psychology Trading Biases

What sets a good trader apart from the rest is the manner in which he handles his emotional and psychological biases while trading. Apart from gaining knowledge about markets, recognizing trends and managing risk, a successful trader should overcome individual and crowd psychology in order to elevate himself to the next level. The market is an extremely competitive environment which tends to test a trader’s skills to the limits and if he is not able to tide over his emotions and trading biases, there are little chances of ending on the winning side in the long run.

Whether we trade in stocks, futures, options, commodities or currencies, in the end profitable trading is ultimately a game of psychology. We should treat trading as a business and separate it from our emotions.

Methods to overcome psychological trading biases

1) Creating a trading plan and sticking to it: It is one of the most important methods to overcome biases. It requires a trader to plan his trade right at the start, rather than planning once the trade is initiated. Trading in an ad hoc manner often leads to loss of capital. It is important that a trader creates a process and trades in a rule based manner. In order to be profitable with a degree of consistency, we need to stick to our process and have a contingency plan set in the event of a major catastrophe.

  • Define your entry and exit levels.

  • Know your limits and avoid over trading.

  • Risk management, maintain a strict stop loss.

  • Diversify your trades.

  • Maintain trading discipline at all times.

2) Focus on research: Place your trades based on thorough research and data rather than market rumors and tips which generally leads to capital erosion.

3) Actively look out for contrary data and views: Traders have a tendency to look for views that corresponds to their own. They tend to think that only the other side of the trade is wrong. If we are going to be able to see things a bit differently, we need to obtain and consider sources that look at events differently. Ultimately the trading decision has to be based on the weight of the evidence.

4) Taking responsibility: A trader needs to have an objective in mind and is required to be accountable for his trades in order to succeed in the long run. He is required to deal with criticism in a positive manner and improve on his shortcomings.

5) Stay away from noise: Day in day out a trader is bombarded with waste amount of data. It is important that a trader is an able to separate a tradable signal from noise. News anchors constantly provide us with data at a high frequency but how often does it result in a profitable trade?

6) Maintain a trade log of your trades: By maintaining a trade log a trader could identify his erroneous trades and improve upon then. Sometimes the errors could be due to pure bad luck but if we are able to identify even a few errors in our trading process it would turn out to be extremely useful in the long run.

7) Stay humble and grounded: A good amount of self-confidence is required in order to be a successful trader. But we often witness that investment success in markets translate into pride and arrogance leading to capital destruction. A few profitable trades is good enough for a trader to abandon his trading plan and place trades on excess leverage and before long, witnessing his entire capital getting wiped off.

8) Understanding yourself: Different traders react differently to profits and losses. It is during times of a winning or losing streak that we get to know the full mental caliber of a trader. A trader often experiences greed for money, a desire to excel over his colleagues and fear. His ability to curtail these psychological biases tends to determine his success or failure.

Overcoming psychological biases is extremely hard, but by implementing the above points we can place ourselves a few steps ahead of the pack.

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