Understanding the Role of Emotions and Psychology in Trading, Analysis and Strategies

In this article, we will discuss

• What is Trading Psychology?
• What Are the Types of Trading Biases?
• Role of Different Emotions in Trading
• How to Overcome Your Biases in Trading?
• Conclusion
• FAQs

Your emotions have a significant impact on every aspect of your life. Even when you trade, keeping aside your skills and analytics, your trading psychology can prove to be a complete game changer. Different stages of trading can invoke different emotions in you and sometimes compel you to make impulsive decisions that you might regret later.

Most traders carry on trading in the stock market as a business and not just as a source of additional income. It is because of this exact reason it becomes so important for a trader to have control of their emotions while executing a trade.

In this blog, we’ll discuss different emotions that a trader experiences while taking a trade, emotional biases, their impact and how you can regulate them.

What is Trading Psychology?

The emotional approach of a trader in the market during profits and losses is what trading psychology is all about. It reflects how a trader handles an unfavourable situation in the market. When the risks in the market increase, most traders often deviate from their original trading plan.

When you execute your trades based on your emotions, you often make impulsive decisions. Since we are all human beings, it isn’t possible to entirely eliminate your emotions from your trade. However, having an understanding of your emotions can help you channel them in a better way. It helps you gain better control over your emotions instead of letting your emotions control you.

What Are the Types of Trading Biases?

With our ability to think, feel, judge, form opinions and understand, we also subconsciously form biases in our minds. Having biases means looking at things from a filter that we have created in our heads. These filters are formed from different opinions, thought perspectives and experiences.

When it comes to trading, there are primarily two categories of biases that play a key role, i.e. emotional and cognitive biases. Let’s take a look at them.

Emotional Biases

As you might have already guessed, emotional biases arise out of the emotions a person feels at a particular time. It can also be a result of their past experiences and behavioural patterns.

For example, if a person is afraid of dogs, they tend to keep away from them. Irrespective of whether the dog might harm them or not, their emotional bias affects their actions.

However, such biases are not always negative and can, at times, help an investor make quick decisions at the right time.

Here are different forms of emotional biases that can affect a trader’s mindset.

• Loss-aversion bias: This is a bias to booking losses. Have you ever invested in a stock that wiped away almost half of your capital? However, you still kept holding onto it in the hopes that it would rise back up.

This tendency to wait for the price to rise back is a loss-aversion bias. You could instead choose to free up your remaining capital and invest it in a stock of higher return potential. 

• Endowment bias: In the psychology of trading, this is similar to the above-mentioned bias. This bias makes a trader feel that what they hold carries more value than what they don’t.

For example, the shares you hold might not be performing too well as compared to other stocks in the industry. However, you continue holding onto them because you feel they will outperform the other stocks one day.

• Overconfidence bias: You might have delivered great trading results in the past. This can make you overconfident in your skills and thus entice you to risk more than usual, be it in terms of the volume or the amount of the trade.
• Regret-aversion bias: We all have sometimes found ourselves in that position where we chose not to take any action out of the fear that it might go wrong. This fear of taking action, because we might regret it later, is an aversion to regrets. Instead of making trading analysis to take trades, you just stop taking any action in this state.
• Self-control bias: This bias arises out of a lack of self-control when we make investment decisions without thinking about the big picture. We make impulsive and erratic decisions for our investments due to a lack of self-discipline.

Sometimes, it is also a result of a hyperbolic discounting tendency where we choose small payoffs in the present over a larger return in the future.

Cognitive Biases

These biases involve making decisions based on some common assumptions that may not always be true. In other words, they are the ‘rule of thumb’ or mental shortcuts that we have created in our minds.

However, they might not always be true. Here are the different types of this bias.

• Confirmation bias: When you start giving more importance to an opinion that agrees with you rather than something that goes against your view, it is confirmation bias. As a result, in intraday trading, you start looking for reasons that back your trading decision rather than trying to find loopholes in your choice.
• Gambler’s fallacy: Sometimes, we, as traders, put undue weight on the past performance of a stock, instead of exploring its future possibilities. For example, just because a stock has been performing well the entire month doesn’t mean that it will continue to perform well in the future as well.
• Status quo bias: This bias arises out of habits and a sense of familiarity. Instead of looking for new investment options in stocks, we keep going back to the same stocks that we know of and feel familiar with. While it is a good idea to stick to your trading strategies, it is also important to change them as per the changing market scenarios.
• The bandwagon effect: In modern lingo, it is what we all know as FOMO – the fear of missing out. You invest in a stock simply because everyone around you is investing in it and not because you have researched its fundamentals.

One of the most popular examples of the bandwagon effect is bitcoins. Most of the investors who bought bitcoins didn't even know what it was, yet they bought it simply because everyone else was buying it.

• Risk-averse bias: When you start putting too much weight on bad news over good news, you become a victim of risk aversion. You avoid investing in some good stocks simply because of the fear that they might give a negative return, and you don’t want to take that risk. Risk-averse investors often choose low-risk investment options over good stocks.

Role of Different Emotions in Trading

There are three key emotions in trading that can significantly impact our decision-making process. Let’s take a look at how they can trigger different biases and the impact they cause. 

1. Fear

This is the very first emotion we all face when we start trading as newbies. Even after years of experience in the market, unforeseen volatility can trigger panic and fear among investors. The COVID-19 pandemic is a classic example of this fear that forced the markets across the world to crash. It can also get triggered in situations when you feel the risk you have taken is too big.

Fear often triggers biases such as risk-aversion bias, loss-aversion bias, or regret-aversion bias.

2. Euphoria

The feeling of euphoria and elation often comes along with overconfidence and greed. It is a result of making a winning streak or entering a profitable trade. This sense of elation can often cloud your sense of judgement and make you a victim of overconfidence bias.

In this state, you might end up taking more risk than what you normally would or can afford. This can also be associated with greed, which compels you to enter a trade out of greed for making large profits. While a sense of euphoria in the outside world is seen as a positive emotion, it can become dangerous when trading.

3. Despondency

It comes after you have encountered huge losses and your self-confidence is at your lowest. This sense of self-doubt and underconfidence can make you become risk-averse, and you might start avoiding taking up any new trades for a while. Some traders can get so hopeless in this state that they might completely give up on trading as well.

How to Overcome Your Biases in Trading?

For more effective risk management, it is important for you to build a better and healthier relationship with your emotions. Here are a few tips that can help you better control your emotions while trading.

• To be able to better control your emotions, it is imperative to conduct a self-assessment. Try to assess your investment goals and your risk profile to give you a clearer understanding of how you should proceed further with your trades.
• The next step is to devise a set of personal rules and trading strategies that you deem fit for yourself. Determine your risk tolerance levels and your expectations of profit and stick to them.
• Before entering any trade, make sure you conduct thorough research on the market conditions and the stocks that you pick. When you are equipped with cold, hard facts, you will tend to avoid your intuitions more because you are aware of the true market conditions.
• Instead of putting in all your money, trade only with the amount of capital that you can afford to lose. When you stop fearing losses, you won’t make impulsive decisions out of panic.
• Be mindful of the harsh realities and risks associated with a trade. Be prepared to exit a trade in losses if the trade doesn’t go according to your plan. While it is good to stick to your trading strategy, you must also be flexible enough to adapt according to unfavourable market conditions.

Conclusion

Your emotions and everyday life significantly impact your trading psychology. Once you learn to control it, you will become less prone to your emotions ruling you. While there is no guarantee of returns in the market, taking the right approach to controlling your emotions minimises your losses.

Frequently Asked Questions

Q1. Can taking large trades affect us emotionally while trading?

Ans. When you take trades with a volume higher than your risk appetite, your emotions tend to become more erratic. To avoid such circumstances, take up trades of smaller volume so that you are more at ease while executing the trade.

Q2. Can journaling help me in regulating my trading psychology?

Ans. Journaling helps you identify your emotional triggers and thus allows you to take measures for such triggers. Identifying your triggers, after all, is the first step towards building a relationship with your emotions.

Q3. How can a trading plan help me regulate my emotions?

Ans. When you have a trading plan hatched in advance, you know what you are supposed to do in any particular situation. Include your risk management strategies, risk and reward tolerance, goals and strategies in your plan so that you don’t get stuck in unforeseen circumstances.

Q4. What are the two trading psychology traits of a successful investor?

Ans. The two most common trading psychology traits of a successful investor are to avoid the herd mentality and never trade in overconfidence. When you follow the bandwagon, you don’t know the technical aspects of price changes and returns, and you can suffer losses. Additionally, an overconfident investor is often incapable of making rational decisions.

Q5. How can I stop overthinking in trading?

Ans. The best way to avoid overthinking in trading is to stand by your trading strategy and stop comparing yourself with the performance of other traders. This can cause a lack of self-confidence and, thus, failed trades as well.

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