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Chapter 1 Trading Psychology

Introduction

For a trader to be successful many characteristics and skills like good understanding of fundamental and technical analysis are a requisite. However, one skill that many traders overlook is the emotional skill, which is as important if not more while trading. Emotional and mental discipline is one of the key parameters that separate the professionals from the average traders.

Significance of trading psychology

A trader has to make several complex and swift trading decisions day in day out. In order to achieve this with a certain amount of accuracy, traders need good mental balance. A lot of times emotions get in the way of the trader making him deviate from his established trading plans which include predefined targets and stop losses. At times, traders end up incurring huge losses as they are unable to manage their emotions during a trade.

Frequently faced trading emotions

Any trader trading in the financial markets constantly faces a number of emotions wherein fear, greed, regret and hope are the four most prominent ones.

Fear

Fear is an emotion that a trader generally encounters immediately after placing a trade. Fear creeps in when the trader observes the trade goes slightly against him, causing him to close out his positions. When this happens, traders generally overreact and tend to liquidate their holdings causing short spurts of extreme movement in the markets.

Short covering is a classic example of fear entering the minds of the trader. In the chart above Nifty futures witnessed a swift increase in prices from 9650 levels to 9950 levels where the markets started to consolidate, coinciding with a gradual increase in Nifty futures O.I. Traders at this levels started to create fresh short position in the futures market, expecting the market to correct as the open interest surged higher along with a small drop in prices. As price of Nifty futures started to increase from 23rd July, fear crept in and traders who were short in the futures market had to run for a cover and close their short positions. This panic was observed by a sharp decline in the open interest positions of Nifty future contracts.

Some of the other common scenario’s when a trader encounters fear are

  • Cut winning position short in fear of giving profits back

  • Hesitate in initiating the trade because of fear of a prospective loss

  • Hang on to losing trades because of fear to take the loss

Greed

Greed is the excessive desire for profits. Greed tempts the trader to stay in a profitable trade longer than is fundamentally or technically advisable in an attempt to squeeze out the last penny. Greed among traders is generally observed in a bull market when traders trade throwing caution to the winds.

We all have had at latest one trade wherein we held a particular stock way to long and then sold out at break even. Greed changes the way we think and prevent us from acting in a rational manner.

In the chart above of CDSL Ltd there would have been many traders who would have purchased the stock only for listing gains, as the stock moved up swiftly. In the following days greed entered their trading plan and the traders would have held on to the stock. On 14th July the stock witnessed a sharp correction of ~20% giving a clear technical indication on the charts to exit the stock .Traders who did not exit the stock by letting greed get the better of them would currently be holding the stock 15% lower than the technical exit levels and 30% lower than its all time high.

Regret

Regret is an emotion which can come both ways i.e. a trader could regret placing a trade or regret not placing one. Regret may lead a trader to get into a trade after initially missing out on it because the stock moved too fast. This leads to a violation of trading discipline and could lead to trader suffering huge losses. All you need to know is it ok missing few opportunities or having a few bad trades. No one can grab all the opportunities the market offers. Once you have obtained this mindset your trading perspective will change.

Chart: MRF

There will always be stocks such a MRF, Eicher motors, and Avanti feeds that we missed out buying. A Missed opportunity is a missed opportunity only in the mind and is part and parcel of trading/investing in the markets. More than four thousand companies are listed in the markets. It is not humanly possible to grab each and every opportunity.

Hope

Trading based on hope is similar to gambling. A number of traders allow hope of recovery prevent them from cutting their losses. When we create a position in the market, bullish or bearish we start out with a trading plan and end up on hope. When the trade goes against us, emotions such as hope enter our mind forcing us to think that if we continue to hold on to the trade a bit longer any loss can get erased. The only way to avoid it is to recognize the factor of hope in your trading behavior before it destroys your capital.

In the above chart of Lupin Ltd which is a weekly chart, traders could have purchased the stock at Rs 1400 taking into consideration it was the long term support for the stock. Two weeks later the stock breached its support levels; a professional trader would have cut his positions and exited with minor losses. A novice trader who let emotions get the better of him and held on to his position hoping that it would reverse would be facing huge losses as the stock is currently trading at 987 levels.

Psychological traits of successful traders

  • Know your limits and do not over trade

  • Risk management is the key to preserve your trading capital and attain trading success

  • Maintain trading discipline at all times

  • Stick to the trading plan set at the start of your trade

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