Trading Psychology
What are emotions in trading?
We have two channels that we use to perceive the world. The first (customarily attributed to the left hemisphere of the brain) is the analytical channel – the stream of thought, we usually think of as rational. The second (customarily attributed to the right hemisphere of the brain) is the emotional channel. We perceive what is happening around us emotionally.
We can better understand the role of both channels when we turn to simple evolutionary biology. Thinking allows us to make sense of the world: to seize opportunities and avoid dangers. Emotions and feelings tell us what is an opportunity and what is a threat. In other words, emotions give meaning to the events we perceive.
In the vast majority of people (this is evolutionary biology again), the emotional channel is stronger. We consider people who are completely emotionless to be cold or even impaired.
Strong emotions usually turn off the rational channel, because the primary function of emotions is to identify danger, they “turn off” thinking, they redirect blood from less important organs (including the brain) to the muscles, they initiate a hormonal response: they prepare the body for fight or run
This is also how emotions in trading work.
What is emotional trading, emotional investing?
The problem begins when the emotional channel starts to strongly dominate over the mental channel. This is when actions occur that traders later say “I don’t know how I could have done that”. This is how the rational channel sums up thinking and acting under the influence of emotion. But… it is what it is – it just works that way.
Strong emotions tend to turn off the rational channel, because the primary function of emotions is to identify danger. Strong emotions are triggered by a strong threat. The emotional response triggers a hormonal response which shuts off thinking, pumps blood to the muscles, injects cortisol and adrenaline (we become stronger, more resilient and more resistant to pain).
It’s a survival mechanism – our body prepares to fight a threat or run away. Here you don’t have to think, you have to be strong, fast, agile, and resistant to pain. Thanks to this, we as a species have survived and dominated the planet.
The problem arises when we have this reaction in front of the computer and strong emotions cut off our thinking, while we need a sober judgment of the market situation (a good rational channel) because we are not preparing to fight a tiger or a bear, but to re-analyze our position on the market when something unusual has happened.
How best traders control emotions in trading
The best traders have both channels functioning well even in the most difficult situations. This means that even under the influence of strong, or even very strong emotions in trading, the best traders are able to make good decisions.
Several important things help the best traders to control their emotions in trading:
- experience
- proper preparation
- the ability to manage emotional reactions in trading
Most of the best traders are capable of acting in spite of their emotions, and even use them in some cases as a source of information about what other market participants are feeling, e.g. during a market panic. A trader may feel strong emotions in trading such as fear, but will still correctly execute multiple entries in a row in a panicked market.
Here, traders who work alone have it easier – they can cut themselves off from emotional news, TV, and just not read upcoming news. It is more difficult for traders who work in trading rooms, because the atmosphere of panic is shared by everyone.
How do you master emotions in trading?
The best tools to control such situations are… special forces. Soldiers there are systematically put in life-threatening situations and they have to act soberly and precisely.
The training that the best troops undergo includes breath control, process management (I will explain in passing) and of course preparation in real life, simulation and visualization for whatever may happen during the mission.
For a trader there are situations that are critical, just like for soldiers – a few wrong emotional decisions can wipe out capital built up over many months.
Therefore – working with breath, good preparation, awareness of threats and knowing how stress reaction works (and how to stop it) are techniques worth learning. The best traders work on their mental taughness using, among others, military methods of working with stress (I write more about it in my Top Investor training here, I also describe the exercises used)
And one more thing – special forces soldiers have much stronger psyche (mental toughness), just like the best traders. And this is also worth working on.
PS. I’m gonna write even more about emotions in trading in the future. This is very important topic and should be mastered well if you want to be a good trader.
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