Psychological Risk In Trading

Psychological Risk is perhaps the biggest hurdle in trading for your own account. There are tons of books written about it. There are tons of essays discussing it and there's even an academic study around this which is termed “Behavioral “.

I highly recommend taking the time to read the paper that was written by Ernst Fehr and Jean-Robert Tyran. The article is a discussion around the illusion which I find to be a fascinating topic with how it relates to trading.

Studies in behavioral finance have shown that many will inherently make the wrong choices when dealing with their own money especially when there's risk involved. This plays straight into trading. Traders that trade with emotion will almost always have a difficult time with success. Your logical side of the brain is easily trampled by your emotional side of the brain which causes you to make impulsive illogical mistakes over and over.

Here is a great article discussing the left brain vs. right brain concept. But to be brief, your left side of the brain is said to provide you with logic and reasoning while your right side of the brain is said to provide you with the emotions and intuitions.

A good exercise here would be to ask yourself, what was the worst day of trading you ever had? What happened that day? What was your thought process? Was it derived based on emotions (fear, pain, greed, anguish, euphoria) or was it based on logic?

Typically this is how these types of days evolve. First you start the day thinking logically. You've done your research and have a good indication of what you want to do based on your analysis. You take a trade and you get stopped out. You then become upset that it didn't work. Your emotions make you feel that the market burned you. You blame HFTs or locals making a stop run or whatever the excuse du jour may be. Now, you're emotional and you decide that you will just jump back in and take another trade to make back your loss. You then place a stop at a level that means nothing to the market and you're immediately stopped out again. What happens next? You're even more upset.

What do you do next, you take another impulsive trade with the same idea of making your money back but you get the same result. This happens over and over and the next thing you know you're down HUGE! This is when the emotions kick in to over drive and you are now operating at an extreme emotional state. You just lost a ton of money and your stress level is over the top. You begin to act extreme around everyone you know. Your spouse sees you in a strange state, your friends can't figure out what's wrong with you. You go into hiding and blame the world.

Is this a logical trading process? Absolutely not. Did you follow your game plan? Originally yes, but from that point on you tried to impose your will on the market. The market doesn't care about our will though and it will crush our ego's in a nanosecond.

In this psychology subsection, I will spend some time discussing typical psychological trading hurdles and thoughtful ways of overcoming them. There's no magical cure for this mental battle but overtime, you become used to the “controlled chaos” that is the market. I will expand upon this in this subsection.

What I thought I would do here is list some common psychological hurdles a majority of traders face and I'll provide thoughtful ways of looking to overcome those hurdles. At the end of the day, the only person we can really rely on in trading is ourselves. No one is going to click that buy or sell button for you. Its important to know this and become self-reliant and confident in your abilities as you encounter the psychological tests throughout your trading career.

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