Recently, high performance professionals have been moving to psychology in order to increase their performance to the next (optimal) level. Athletes and executives were early adopters to coaching and are now embracing psychology to ensure that there is nothing “inside” that is preventing them from improving their performance.
Trading psychology was brought to common acceptance by Dr Van Tharp. Van Tharp, a clinical psychologist and trader decided to combine both and come up with a whole new way of looking at and improving trader performance.
Trading psychology largely deals with the emotions that disrupt trading ability, and in particular adversely impact on trade execution. These are largely issues of performance anxiety; the trader’s fears of failure that are impacting on his or her ability to stick to the defined trading plan.
These performance anxiety issues can occur when a trader moves from demo trading to live trading, increases his or her trading account towards a psychological level of return (100% or $1,000,000 for instance) or starts trading a new market.
The major emotions that effect performance anxiety are fear and greed.
Fear is the emotion that prevents a trader from initiating a trade in the first place, makes the trader close losing positions before they have hit their predetermined stops and close out winning trades ahead of profit targets due to fear of the trade turning into a loser.
Greed is the emotion that causes traders to hold positions longer than they should and causes traders to moves stops away from price – one of the cardinal sins of trading.
So how does the trader ensure that their trading psychology is in tip top condition? The two major methods for a trader to manage their psychology are setting trading goals and developing and adhering to a trading plan.
Setting trading goals is not simply a matter of determining an expected profit target. It is easy to say “I want to make $1mln trading in the next month”, but there are other areas that goals need to be set as well. The trader may set goals in regards to time spend trading, time spent educating themselves on trading and which markets to trade.
The best way to set goals is to use the “SMART” goal setting frame work. Smart goals are:
Using this system, the traders goal setting should be easier and by actually writing this goal plan down, it will be an easy reference document for the trader to keep in mind.
Successful traders should also use a formalised trading plan to limit their trading psychology issues. A complete trading plan generally includes the entry and exit system and a money management system.
The entry exit system is, as expected how the trader actually enters the trade. What markets to trade, whether to be long or short and at what price. Most traders use technical analysis for their entry and exit system, as it takes the “gut feel” out of the decision. Technical analysis is the use of charts and mathematical algorithms to deduce trend and trend strength, support and resistance levels and potential profit targets.
The money management system describes how much risk to accept in the trader’s system. Money management defines where the trader should place their stop (how much the trader is willing to lose on a trade) and the defined risk/reward ratio that the system requires.
Stop placement is one of the hardest aspects of trading. The trader’s money management system seeks to simplify this issue by defining a maximum loss that the trader will accept on a trade. If the system defines a maximum risk of 2% of account balance on a position, the trader will not take trades where appropriate stops can’t be placed within the preferred maximum loss the system will accept.
The risk to reward ratio helps a trader define where profit targets should be placed. Is it the ratio of profit expected to acceptable loss. If the trader is willing to risk 2% of their account on a trade and their account balance is $200,000, then the maximum loss acceptable is $4,000. If the profit needed to make this trade acceptable is $8,000, that would be a risk/reward ratio of 2:1 ($8,000:$4,000).
As can be seen, by using a defined trading system and a money management system, the trader can seek to mitigate issues surrounding trading psychology.