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Importance of Trading Psychology

In the commodity markets, there are two forms of analysis: Fundamental Analysis and Technical Analysis. The former studies the economic equation of the demand and supply of the commodity while the latter demystifies the charts and decodes the various chart patterns and behaviours using various tools and indicators. Although these two schools of thought are deemed to be more than adequate to set up a position, there is another branch of learning which is quickly rising the ranks: Trading Psychology. The traders often overlook trading psychology in comparison to the other two which ultimately marks the downfall of a trader.

What is Trading Psychology?

It refers to the emotional and mental state of the traders that dictates the success or failure rates while trading in the financial markets. It encompasses various facets of a trader’s character and behaviour that drives their trading decisions. Trading psychology can be attributed as an important element coupled with knowledge, experience and skill.
The two sides of the coin: Discipline and Risk-Taking, are the most vital aspects of trading psychology since the implementation is critical in the result of the trading plan. Traders who comprehend trading psychology will inevitably avoid making decisions based on emotions or biases. It will assist the traders and provide a better chance of earning profits during a trade or minimise the magnitude of losses.

Basics of Trading Psychology

With each trader, trading psychology is different and is influenced by the trader’s emotions and thought processes. However, given the vast scope of psychology, trading psychology is normally explained concerning two contrasting emotions: Greed and Fear.

As in any walk of life, greed can be explained as an excessive craving for wealth and therefore cloud rationality and judgement. The characteristics of a greed-induced trader are based on the assumption that greed can lead traders towards a variety of suboptimal behaviours. This includes initiating high-risk trades and buying the financial asset without researching the underlying investment. Greed also inspires traders to continue with profitable trades than originally planned to generate extra profits or to initiate large speculative trades. In the trading cycle, greed is most prevalent in the final phases of a bull market where speculation still exists and traders throw caution to the wind.

On the contrary, fear is an emotional state of mind that influences the trader to close out trade prematurely or resist initiating new trade due to concern of incurring large losses. Fear is relevant during bearish markets because traders act irrationally in their quest to exit the market. Fear often translates into panic which causes mass selling in the financial markets. One of the important issues is that regret may drive a trader to enter a trade setup after initially missing out on it because the financial asset moved too rapidly. The preceding scenario violates the essence of trading discipline and often results in losses from financial assets that are declining from their peak high.

Ways to Improve Trading Psychology

• Personality Traits Identification
The trader should identify their personality traits early into their trading career and draft a plan to negate unhelpful traits. On the other hand, a trader should identify positive traits also, those that can assist him to make the right calculated moves during their time in the market.

• Draft a Trading Plan
Also known as a trading blueprint, a trading plan will highlight the goals that a trader anticipates to achieve, the risk-reward ratio and the trading strategy that the trader is willing to implement. In the trading plan, a trader schedules trading durations for the day identifying profit targets and stop-loss levels to eradicate emotional aspects of trading. During the creation of a trading plan, traders should consider definitive factors such as emotions and biases that can potentially influence the ability to stick to the trading plan.

• Research on Financial Assets
Traders should devote ample time to research and review trading opportunities before investing in any financial asset. Following the news, studying charts and graphs are some of the critical tools to stay on top of the game. In recent times, traders are also following top trade analysts and pundits on various social media platforms to process their work and get a headstart on market dynamics. Traders should always upgrade their knowledge and understanding of financial markets by regularly attending webinars, seminars and conferences where they get an opportunity to share and interact with the other market participants. The information gained from such platforms is priceless and traders can use such information in their day to day trading practices.

Conclusion

Various research studies in the commodity markets show that trading psychology forms a significant aspect of trading as it was evidenced that traders lost money when there were more winning trades than losing trades. Traders often have to think fast and make quick decisions in financial markets. To achieve optimum results, traders require a certain presence of mind. Simply put, emotions should never get in the way.

 

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Vivek Risal is associated with Mercantile Exchange Nepal Limited in the capacity of Manager in Research and Development Department. He can be contacted at r&[email protected]

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