Trading Psychology Is Important!

From my early days in trading stocks, I am a strong believer that the three important components of stock trading are the 3M - Mind, Money, Method.

Understanding money management is not that difficult if you understand the concept of position sizing and act on it. To come up with a solid method (or some say Holy Grail) is rather difficult and more time consuming. But the most difficult is actually to understand (and act upon it) the trading psychology - MIND.

CC Image courtesy of lisainglasses on Flickr

Let's first introduce trading psychology and why it is very important to every trader. Let me quote Brett Steenbarger that wrote neatly and precisely many articles on trading psychology. The relevance of psychology for trading is based upon two important realities:

#1. Trading is a performance activity, much like athletics or performing arts. Psychological variables influence both the acquisition of skills in any performance field and the application of those skills. While there is much more to performance than mindset alone--talents, skills, and interests must align--the wrong mindset can greatly hamper performance. 

#2. The human mind does not process information efficiently or effectively under conditions of risk and uncertainty. To simply "trade what you see" is a recipe for falling prey to a variety of cognitive and emotional biases. The trader's psychological development is crucial to learning how to properly gauge risk and reward when performance pressures mount.

These points are relatively true in most things what we do - as far as trading is concerned. In trading, the four main emotions - fear, greed, hope, despair - are our enemies, if we do not control them properly (of course a little bit of fear and greed is good). Hence understanding the NEEDS of trading psychology is a good start for all traders - novice or experienced.

When trading psychology is not properly handled, we see many examples of disaster in trading: making impulsive decisions, allowing fear to overtake opportunity, over-trading, allowing losing trades to run and capping winners, and the like. If you can make those mistakes - and learn from them - long before you put the lion's share of your capital at risk, you will have an opportunity to grow into the trader you're capable of becoming.

Breet mentions in one of his articles that the best therapy for improving trading psychology is to get into the therapy yourself. To go to stock markets with poor psychological aspect in your trading skills is very expensive. Psychological development needs to precede trading development: resolving those issues is the best way to approach markets with a clear and open mind.

When you have improved your trading psychology, you will notice that you will recognize when others are making the mistakes you used to make. You will see markets acting on fear and greed and you'll be able to take the other side of those reactive trades. You'll observe when market sentiment is tilted one way and price can no longer sustain its trend.

"Developing yourself psychologically doesn't mean that you'll be free of emotion. It means that you will become increasingly competent at using your feelings as useful trading information."