The Importance of Mental Health when Day Trading

The Importance of Mental Health when Day Trading

The Importance of Mental Health when Day Trading

For most day traders, trading is all about indicators, stock screeners, and economic reports among other factors. Seldom do day traders realize that there are a lot of things in play when it comes to determining a winning and a losing trade. Thankfully though, in most cases, the human mind does an amazing job that it is often unnoticed, unless you pay close attention. You will quickly discover how your mind starts to process the information and thus, in the process having a sound state of mind and a positive attitude can influence the decision making process.

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Just about every simple aspect of trading can be seen as a result of psychology. Traders who are able to remain patient at trading and wait for the right opportunity are merely ones who have managed to take control of the psychological aspects of trading, as compared to a new trader who is yet to find a balance in waiting for the right set ups to occur.

A simple task such as buying and selling a security requires the mind to factor in the information that you have researched on, the clues from the technical indicators or if you use any or the clues from the price action itself as well as doing quick calculations as to how much funds to allocate or risk to a trade, where to set your profit and stop loss levels and so on.

All of these tasks and some more are done subconsciously and in a matter of less than a millisecond. When you start looking around, you will sooner or later realize that having sound mental health is essential when it comes to your long term trading success. This is not just true for day traders or investors, but also in just about any field.

Take a look at sports, which often seen as one of the closest fields that can be compared to day trading. Athletes don't just spend time in honing their skills but also dedicate a good amount of time in shaping and training their mental health or psychology as well. It might sound clichéd to say this, but battles are first won in the mind. Similarly, an athlete has already won or lost a race in their mind, and the same holds true for a trader as well. If you had a bad day and you decided to trade, chances are that your distracted mind will eventually mislead you into taking trade that could result in a loss, unless you got quite lucky in picking the right security to trade.

Trading psychology – Dealing with winners and losers

Trading psychology – Dealing with winners and losers

Trading psychology is not something new and there have been endless amounts of materials and research done into how to train one's mind to be successful in trading. Trading psychology is a very important aspect to trading because, the market after all exhibits a collective psychology of the other investors. Consider the example of a bull market, where the markets are rising. Investors are buying into the rally because they are collectively bullish on the markets, perhaps for reasons known or mainly just simple greed based on peer pressure.

Likewise, there are many instances when even good news in the markets turns out to be a reason to sell. Such moments signal a pessimistic outlook from investors and no matter what, the markets just seem to look at everything as half empty. Thus, when dealing with the markets that exhibit the collective psychology, as a trader it is important to not just understand this behavior but also train one's mind such that the trader is in better control.

Psychology in trading thus has two important functions. Firstly, the market itself is a reflection of the wider investor psychology and simply reflects the mood of the investor and secondly, the trader’s own psychology plays a bigger role when it comes to determining the success of the market.

Stock prices do not move because a short term moving average crossed above a long term moving average or because there was some other technical trigger. Stock prices move because of human emotions. Even though high frequency trading or algorithmic trading has increased over the past decade and more and more traders are now controlled by logic and conditions, humans still remain the major market participants in the stock market. Therefore, it would be futile to brush aside psychology in trading.

The Psychology of Fear and Greed

When talking about psychology, there are two words that are often throw out in the open. Fear and Greed!

Fear in the stock markets is when investors shun risk and seek safety in assets that do not yield high returns (or yield any returns in some cases) but simply as a protection of one’s capital. The general thinking here being that the investor is too afraid to invest their money for fear that they would end up losing their capital rather than make any profits.

Fear and Green Cycles as seen in the CBOE Volatility Index

Fear and Green Cycles as seen in the CBOE Volatility Index

Greed in the stock markets on the other hand is when investors seek higher returns, thus taking on higher risk. Here, the general conception is that investors are optimistic on the economy or the general stock market and thus, willing to take on more risks.

These same emotions also play a significant role when it comes to an individual trader as well. For example, would you be taking on more risk by adding to your positions when you are fearful? Or have you ever wondered how a winning streak usually starts, one winning trade after another and you start increasing your position sizes?

This is nothing but fear and greed in play on a personal level, while the broader stock market cycles are a reflection of the wider investing community. The stock market crashes in history are nothing but these psychological cycles in play, triggered by investors as a result of some bad news.

In most cases, during the peak of the stock market crashes, you will often find central banks and even governments coming out in support. Usually, the narrative of the time being that central banks threaten to cut interest rates or pump money into the economy. These words, in many cases have proven to soothe investor sentiment thus slowly lifting the stock markets back on track without actually having to implement any of the points that were talked about.

To illustrate the power of sentiment in the markets, take a look at the most recent Dow Jones Industrial Average chart below. The period of interest in November 2016 after the U.S. presidential elections saw a surprise outcome of Mr. Donald Trump emerging as the 45th President of the United States.

The markets fell sharply on the day of the announcement of the results as investors were unsure on how the protectionist policies of Trump would fan out. However, Trump later in the day reassured investors and soon enough started to shift focus on the fiscal stimulus plans and tax reforms.

The mere thought of this was enough to sway investor sentiment from one extreme to another and has fuelled another leg in the stock market rally that saw the Dow Jones break past the 19,000 and briefly trading near the 20,000 level.

Dow Jones Industrial Average reaction to the U.S. elections and the market psychology there after

Dow Jones Industrial Average reaction to the U.S. elections and the market psychology there after

You can see how the psychology was at play here that helped to fuel the rally. Of course, the stock markets got some boost from the U.S. Federal Reserve as well which was hawkish on its economic outlook and was in a rate hike cycle.

Another classic example of the psychology in play is the now famous term, Irrational Exuberance. The term was coined by Alan Greenspan, a former chairman of the U.S. Federal Reserve. He used the term irrational exuberance to describe the market frenzy in the pre dot-com bubble in 1990’s. Some believed that Greenspan used the term to describe the fact that the stock markets were overvalued. Interestingly, following his comments, the equity markets that were open at the time, in Japan plunged over 3%.

How trading psychology can help you?

By developing discipline and keeping emotions out of the picture, day traders can use trading psychology to their advantage, not just to make profits but also to minimize risk as well, especially when things go bad.

A common way traders lose money is when they start adding to a losing position. Describing these moments may seem simple on paper unless one has really experienced this. The conviction that one’s analysis is right, and that the market will reverse direction in the next few pips is one of the reasons why traders find it difficult to cut their losing positions.

At the same time, it is trading psychology, or the lack of it that often puts a trader in a fear more such that they end up prematurely cutting short a winning trade.

While a bit of market knowledge is also essential, in most cases, it is the emotions that often lead to such immature decisions by traders that turns out to be costly experiences in most cases.

How to maintain a healthy mindset?

For day traders who are used to trading in and out day after day, it can start to become tedious, if not monotonous when it comes to day trading. This can be even more accentuated if you are specializing on just one particular market. For example, it is common to find quite a few successful futures day traders focus on just trading the E-mini S&P500 futures contract.

While one can easily dismiss the monotony and keep going at it, over a period of time, the day trader can fall into a bias in the markets, which can lead them to making wrong trading decisions. Another factor is when a trader takes a loss. Sometimes, depending on one’s conviction on a trade, this can be even more significant as the trader’s mindset would be stuck into a bias and would lead to repeated analysis that in one way or another carries the same bias.

To maintain a healthy mindset, the first step is to take a break from the markets. This means not having to look at the charts for a while in order to clear up any preconceived notions one has about the markets. Referred to as looking with a fresh set of eyes taking frequent breaks can help traders to not only break the monotony of trading, but also helps to identify new trading opportunities or even risks that they failed to see previously.

It goes without saying that to keep a healthy mindset, traders need to also focus on meditating or pursuing a hobby that they like, something which is completely unrelated to trading or the financial markets. Some traders like to think that they are taking a break, when in fact they either end up reading about a book that has to do with the markets, or watching a documentary about the financial markets. Pursuing hobbies, especially one where physical activity is requirement can be a great way to exercise oneself physically and mentally.

Traders should also focus on other aspects such as their surroundings. Dealing with an unhappy situation with someone at home or dealing with a serious loss can also impact the human mind. Therefore, it is often said that traders (especially if you day trade for a living) should know either how to deal with their emotions or stay off the markets until they deal with the psychological obstacles.

Remember that although it is very easy for anyone to become a trader, only less than 20% make the final cut. The statistics that more than 80% of new traders lose money is not a fictional number but real. Trading might seem easy especially when the money starts to flow in. However, a trader is often tested when their trades go bad or when they take a big hit to their equity. Quite often, only the ones who pick themselves up and continue to move on, while learning from their mistakes are the ones who manage to make it till the end with some of these even managing to make a decent profit.

If you haven’t yet thought about the important of trading psychology, take some time out and look back at your trading results. In many cases, the answer to why you cut short a winning trade, or added to a losing trade, or even made a big profit lies in your thinking at that point in time.

Al Hill Administrator
Co-Founder Tradingsim
Al Hill is one of the co-founders of Tradingsim. He has over 18 years of day trading experience in both the U.S. and Nikkei markets. On a daily basis Al applies his deep skills in systems integration and design strategy to develop features to help retail traders become profitable. When Al is not working on Tradingsim, he can be found spending time with family and friends.
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