The psychology of trading can be just as important as the method chosen, the system development, the strategy used and risk management. Without the right mindset using clear rational and disciplined thinking nothing will work over the long term to create profitable trading as mental errors will sabotage any trading edge.
The three primary mental mistakes that new traders make are experiencing FOMO (The fear of missing out), revenge trading, and the gambler’s fallacy. Here are some ways to manage the mind to stop repeating these errors.
How do traders deal with FOMO?
FOMO is an acronym that stands for the Fear of Missing Out on an opportunity, event, or chance to make money.
FOMO can come from the feeling traders have on social media when they see other people saying they made money and create the feeling that they are missing out on trades and profits.
In trading and investing FOMO is also the psychological error of seeing a move in a market that you are not in but have a strong desire and want to get into a trend which usually happens too late.
The fear of missing out can make you want to enter a trade outside your trading plan, system, and without a valid signal with the emotional desire to participate in a strong move that you missed out on but is still going on. The fear is that you will completely miss out on a big profitable opportunity so you decide “Better late than never!” and this is almost always a mental error. FOMO usually leads to chasing a chart near the end of the opportunity and leaving you with a loss.
The best way to combat FOMO is to believe that a current opportunity is just one of next 100 you will have in the future and all you have to do is wait for the next one.
A trader should also focus on their own watchlist and strategy and not tempted to break their own system to start gambling on charts outside the parameters of their own quantified edge.
A real trader should also stay inside their time frame and avoid the temptation to gamble. Running your trading like a business requires you to operate your system not chase random bets.
One trade should never have much meaning to a trader that thinks about the big picture and long-term trading success.
The value of an opportunity is found in the timing and if your entry is too late what appears to be a blessing can quickly become a curse.
Temptation, jealousy, and greed are all emotional signals triggered by FOMO and the cure for them is discipline and focus on your own system and edge. Too many traders can drown in losses chasing rainbows that turn quickly into waterfalls.
FOMO can be expensive.
How to prevent revenge trading
Revenge trading is the irrational desire to win back your losses from the same market, chart and stock that you lost money in.
Revenge trading is commonly triggered by the ego feeling beaten by a stock and wanting to get even with the chart by making their losses back in new profits. A trader can become obsessed with making the money back on the same chart that they lost it on to feel a return to even for trading it. They can feel they are better or won against an imaginary adversary or the market.
This is a big mental weakness for people that are very competitive, hate to lose, and always want to prove they were right.
The simple solution for this is to not take any loss personally, follow a system with a diversified watchlist and move on to the next trading opportunity. With proper position sizing and risk management each trade should just be one of the next 100 trades and not engage the ego in battle against a chart they lost money on.
Why is it Important to Avoid Revenge Trading?
- It makes you blind to other trading opportunities.
- You allow feelings to override your trading plan.
- You don’t have to make back money the same way you lost it.
- There was a reason you lost money in that trade, don’t revisit it.
- Revenge trading is not a part of a profitable trading system.
Never put your desire for revenge due to a losing trade over your long term goal of profitable trading.
Gambler’s Fallacy Psychology
This mental error in thinking is the failure to understand the independence of chance in random events. This leads to the error in belief that you can predict the outcome of one random event based on the outcomes of previous events leading up to it.
The mental model of the gambler’s fallacy is the erroneous belief system that a random event is less or more likely to occur based on the results from one or multiple previous events. They believe that something is more or less likely to happen based on unrelated events or data.
The classic example of the gambler’s fallacy occurs when someone flips a coin or is at the roulette wheel. If the head lands face up or the ball lands on black, four or five straight times, the majority of people will think that the coin now has greater odds that it will land face up on the tails side next time or the roulette is due to land on red. They will argue that the repeated heads on the coin or black on the roulette wheel increases the odds of a future tails on the coin or red on the roulette wheel.
The reality is that each random event is unique to other events and do not affect each other. The edge the casino has is in large sample sizes and thinking more in terms of after 20 roulette spins it will be closer to 10 black and 10 red results than an unbalanced odd number and their edge is in the ball landing on the extra green spot when people bet on red or black. Each coin flip is an individual event with a 50% probability of going either way regardless of previous flips.
Traders must understand that every trade in the market is unique, every trade has an uncertain outcome. No chart has to bounce higher no matter how many times it has gone down and no next trade has to be a winner based on how many trades were losses in a row previously. Anything can happen at any time and this is why trader’s need stop losses, trailing stops, and proper position sizing to manage the uncertainty.
A profitable trader must think in terms of a positive expectancy model over a large sample size of trade signals when each trade is managed for minimal losses and maximum returns. Successful traders use discipline, logic, math, and focus to overcome mental errors to create profits.