Most beginners and even many experienced investors believe that success in financial markets is determined by the right strategy and trading system. However, after some time, they face disappointment as perfect signals and precisely formulated capital and risk management rules lead to losses instead of the expected profits. The reason is that these ideal rules are not followed under emotional pressure. Thus, controlling emotions is extremely important for market participants. Everyone should know how to trade with a cool head.
Emotions in Trading – Impact on Results
Many successful traders claim that psychology has always been the most crucial component in financial markets. Dr. Van Tharp, a trading coach and practicing trader from the USA, created his own chart (Tharp’s Chart), evaluating the impact of various factors on trading success. According to his chart:
- 10% goes to the trading system – determining optimal entry and exit points.
- 30% to money and risk management – calculating trade sizes, structuring assets, and setting profit and loss limits.
- The remaining 60% to the trader’s psychological preparation or emotional control.
Psychologists working with traders identify two main emotions that hinder achieving positive results:
Fear
Fear manifests in trading as a desire to avoid losses. While it seems like fear in the right concentration should prevent traders and investors from making rash decisions, it almost always leads to negative results.
Market participants’ fear has several manifestations:
- Primary fear. Almost everyone experiences this before making their first trade in a new market, on a new platform, or with a new asset. It appears as anxiety and indecisiveness about entering the market. Internal arguments can range from needing more study or analysis to the belief that trading is not suitable for the average person. This emotional state can become chronic, causing the investor to delay making trades for months, leading to no real results.
- Secondary fear. Typically found in those who have already experienced losses in trading. This fear is much stronger, as anxiety about negative results is backed by past experiences. Through this lens, even the best market analysis and forecasts seem unconvincing or wrong, and any trade appears potentially losing. This also leads to another negative outcome – the trader loses the ability to perform quality analysis, becoming inattentive and distracted.
- Fear of an open trade. In this scenario, the trader enters the market but, driven by fear, closes a potentially profitable position at a small loss or after a slight profit. The main problem here is a lack of confidence in achieving results and an inability to wait for them. Consequently, even a profitable strategy can turn into a losing one.
- Hope. An emotion that seems entirely positive at first glance. However, for many traders, it becomes a manifestation of fear, synonymous with the fear of even minor losses. In hope that the market will correct the situation, a trader might not close a losing trade, leading to increased losses.
Many believe that controlling fear is simple – just identify its first manifestation and either refrain from acting or do the opposite. However, this approach isn’t always correct; fear can be genuinely justified, driven by critical thinking and a sober assessment of the situation. Therefore, it can be extremely useful for a trader.
Greed
Trader greed typically manifests as a desire to extract too much from the market. This emotion can be observed in the following behaviors:
- Lack of stop-loss orders.
- Attempting to hold profitable positions for as long as possible, such as by moving the take-profit target or ignoring signals to close in the belief that the market will continue to rise after a slight correction.
- Entering a trade at the slightest market movement.
- Increasing the position size as soon as it starts to become profitable.
- Using maximum leverage.
Greed is the opposite of fear in all its forms. Usually, only one of these strong emotions hinders a trader. This simplifies the task of overcoming them to achieve positive results.
Psychologists working with traders identify two variations of greed: excitement and overconfidence.
Excitement is the urge to make another profitable trade immediately after closing the previous one (the market is moving in the desired direction, so more profit should be made) or to quickly recover losses from a mistaken entry. In such cases, little to no analysis is performed, often resulting in increased losses.
Overconfidence or euphoria typically occurs after a series of successful trades. The trader becomes convinced that their analyses and forecasts are absolutely correct, believing the market should move in their chosen direction and that any contrary movement is merely temporary. Consequently, the number of incorrect entries increases, and losing positions are only closed after losses exceed all imaginable limits. Needless to say, profitable trading becomes a distant dream.
How to Handle Emotions in Trading
Experts suggest three effective methods for dealing with the negative impact of emotions on trading results:
- Turning emotions into allies. When a trader feels fear or greed, they should concentrate fully and exert all efforts to achieve success. This method has proven effective; some traders can’t even make a trade without an emotional surge. However, this approach is not always rational as it can lead to quick burnout.
- Achieving emotional balance. This involves the trader monitoring their state to recognize emotions at their earliest stages. This allows them to quickly restore balance and make decisions in a calm environment.
- Complete suppression. A common approach among professional traders is to learn to execute trades regardless of their emotional state (similar to trading robots). This approach is considered the most rational, as it is relatively simple and straightforward to implement.
Practical tips for controlling emotions:
- Have a detailed trading plan for each trade. The plan should specify all conditions and parameters, including volume, entry signal, stop-loss level, take-profit level, trailing stop conditions, and closing options without stop orders. The plan must be followed meticulously.
- Practice decision-making on a demo account. Decisions should be practiced to the point of automatism, as trading on a demo account involves no emotional pressure. This will minimize the impact of emotions when switching to a real account.
- Pause real trading when emotional trades are suspected. Continue to create trading plans and analyze trades without actually opening or closing positions. This will help identify problems in the trading system and strategy, and determine the percentage of emotionally driven trades.
- Evaluate results over the long term. This helps to overcome the fear of losses and critically assess the consequences of greed.
- Accept that Lossless Trading is Impossible: To combat greed, accept that it is impossible to profit from every market movement completely.
- View failures as learning experiences. Consider losses as the cost of education, which motivates a more detailed analysis of trades and the development of corrective measures.
While emotions are not always detrimental to trading, fear and greed must be controlled. Satisfaction from results and joy from well-executed trades can be powerful motivators for successful trading.