Trading Psychology – We can never be neutral in our emotions. No matter how hard we try, we will always feel something, in some mood, and in some direction. For traders who think this is a bad thing when it comes to the markets, think again. Emotions can (and to a certain degree have to) be an integral part of your trading routine.
Simply put, without emotions, you’ll end up making erratic decisions based on impulse. If and when you remove emotions from your trading, you’ll end up in a very dangerous position, left with impulsive decisions based on a whim.
An important theory in regards to emotion and how we can understand it as it pertains to trading is the Somatic Marker Hypothesis. This is a theory proposed by Antonio Damasio in which he described emotions as experienced through bodily states.
Imagine the idea of following your gut. In this situation, the body is signaling an emotional reaction to a certain situation. The intuition provided by the emotional state gives us an idea of which path to follow and can help us make a sound decision. If we are empty of emotion, we lose this valuable guide. Emotions are proved to be crucial in our decision-making process.
Now apply this to trading. Imagine you have a perfectly good trading setup that has performed well in the past and shows no obvious signs of failure in the future. Your emotions towards this setup would obviously be positive and encourage you to continue operating with this fruitful setup. If there were no emotions involved in the decision to use this setup, you wouldn’t have such a positive gut feeling towards the setup. Emotions guide and encourage you to continue with this setup, rather than make a poor decision like abandoning it for something potentially perceived as more logical.
Doing away with the myth that emotions inherently lead to irrational decisions, researchers have shown that emotions are instead an integral part of the decision making process. Emotions are not all the same and therefore shouldn’t be treated as such. While there are certain emotions that will lead to irresponsible and ill-advised decisions, there are also plenty of emotional responses that can guide us towards the right decisions. This is not to say that emotions should be categorized as either good or bad. There is a grey area and there is room to work on both sides.
The researchers who discovered the multifaceted nature of emotions identified four primary functions of emotions. We can take these four functions and apply them to the mental aspect of our trading routine.
The first function of emotions is to provide information. That is, they help us in our understanding of situations and the possible options or alternatives to said situations. For example, when a trader finds a good setup, emotions can guide in the pursuit and implementation of the strategy. A good setup brings feelings of excitement which in turn influences trading psychology decisions.
The next function of emotions is how they might accelerate our decision-making process. In the context of trading Psychology, this means that emotions can enhance a trader’s ability to make quick, necessary decisions. For example, a trader might be in a short trade when they see their trade stall. Along with this action, the trader might experience apprehension that the market is no longer moving in the direction planned. This sudden rush of emotion will help the trader make a quick decision before price can rally against them.
The third function of emotions is as a tool to focus attention. Emotions help us evaluate a situation by zeroing our attention in on the information that is most relevant to the circumstances. An example here would be if an experienced trader sees what appears to be a can’t miss trade. However, something in the trader’s gut tells them to take a step back and look at the trade over a longer period of time just to make sure everything’s in order. Emotions directed the trader to focus their attention on the larger picture and to obtain all the relevant background information.
The last function of emotions is to help us choose and stick with a decision. Feelings of confidence can reinforce a made decision and allow us to stick with it without fear or doubt. A confident trader is better prepared to stick with trade rather than impulsively bailing because of a slight setback.
While we can write all day about the importance of emotions in trading, it’s irrelevant unless you’ve opened up to them and embraced them. Emotions can be a force for good but if you’re not using them or acknowledging them, it won’t make a difference.
In order to familiarize yourself with and to embrace your emotions, there is a fun little exercise you can do to visualize your emotions and potential response to them. In the chart below, we’ve identified a scenario, the information associated with it, the speed at which it’s occurring, the attention devoted to it, and the commitment that comes along with it.
Map out a table for yourself and go through various situations and the emotions associated with them at every stage. Contemplate how you would react, how they would make you feel, etc. This can be a very helpful emotional preparation before you’re thrust into a position with no previous preparation.
While moderate, controlled emotions can lead us to make sound and wise trading decisions, strong, uncontrolled emotions will not. The idea in embracing and controlling emotions is to harness these out of control feelings so they don’t lead us down a path of ill-informed, irrational decision making. We cannot let our decision making be hijacked by extreme emotional tugs. Rather, we need to be aided by composed, controlled, understood emotions.
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