The Psychology of Trading

It is even perhaps the most important because it is the psychology behind trading which will ultimately determine whether you succeed or fail as a trader. Whilst being able to read a chart using price and volume is important, without an understanding of why trading really is ‘all in the mind’ you are doomed to fail, or locked into a cycle of behavior, which will destroy your wealth, and sometimes even your health.

Trading, when distilled down, is really a question of how well you can manage your mind.

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These may seem harsh words but they are a fact of life, and in this chapter, I am going to try to explain to you why, as a trader, you need to treat the mental aspect of trading with as much respect as any technical or fundamental analysis of the market. I am also going to explain why you need to understand just as much about what is going on in your head when you trade, as you do about the market.

As traders, we are constantly told that having the right `mindset’ is paramount to success. We are also told that a successful trader needs to be `disciplined’ and needs to remove all emotion from their trading decisions, which I can assure you, is easier said than done. Trading psychology books and manuals will also stress the importance of having a trading plan, as well as the significance of our personal beliefs about money and risk. Most books will also explain how such deeply held beliefs about money and risk can cause traders many problems, and because often these beliefs are unconscious, they only manifest themselves during the trading process.

In other words, because trading is about loss and risk it can, and does, make us face up to our innermost beliefs about ourselves, our view of the world and can even trigger deep fear and emotional responses more commonly associated with stress and trauma. In many ways, trading is the mirror which reflects an internal world which we rarely consider or examine. Trading forces us to face up to these inner thoughts and feelings. It is the mirror which we rarely view.

During my live webinars and seminars, I always explain that trading is so stressful it can trigger our flight or fight response. This is the response that kept us safe during our early evolutionary history when most decisions were likely to be whether to face the ‘tiger’ (or another wild animal) and fight and face possible death or run for safety and lives to fight another day.

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In my rooms, I also highlight what I call the `unholy trinity’ of trader fears. The first is the fear of a loss. The second is the fear of missing a trade, and the third, and perhaps the one which causes traders so many problems, is the fear of losing a profit. It is this fear which makes traders cut short their profits, and is the single reason brokers have given me as to why so many traders fail. However, before I move on to explain how to combat and overcome these fears I want to clarify how and why our `trading brain’ is so easily hijacked by these fears, and what happens when one of these fears is triggered.

But first a very short lesson in evolutionary biology.

Our brain is a truly wondrous organ, capable of great feats of imagination and creativity. Our brains also have an almost infinite ability to learn. We are the only creatures on this earth blessed with the ability to think highly complex and abstract thoughts. Our brains are designed to seek out novelty and rewards social interaction with the release of the chemical oxytocin, which makes us feel good. We are biologically stimulated to love or hate what is most familiar to us, and we are built to form attachments and to value what we own.

We are also the only creatures able to delay gratification. Studies in the relatively new field of neuroeconomics have shown that forgoing a present reward for a larger reward later, re-quires intense activity in the mature part of the brain, namely the prefrontal cortex, located at the back of our frontal lobe, and is part of the neocortex. As the name suggests, the frontal lobe sits at the front part of our brain.

It is the prefrontal cortex which is also responsible for higher level thinking, as well as our ability to concentrate, plan and organize our responses to complex problems. It also searches memory for ‘relevant experiences’ or previous patterns, and it is capable of adapting strategies to accommodate fresh data whilst also housing working memory.

From the above description, it is abundantly clear that this is the part of the brain which should be engaged when we trade. It is the part of the brain which allows us to make cool, logical and common sense trading decisions based on a clear analysis of our charts. Sadly, it just does not happen, and the reason for this lies in our evolutionary history.

Moreover, this area of the brain is the most recently evolved as our brain is the result of a long process of evolution, with a timeline counted in millennia. In very simple terms, the easiest way to understand our brain evolution is to use the ‘triune brain theory’, first developed by Paul McLean. In this theory, evolution has delivered three distinct brains and stages of development which now co-exist inside our skull. These three do not operate independently but are linked via a highly developed and complex web of neural pathways.

The first (and oldest) is the reptilian which controls our vital functions, such as breathing, heart rate, and temperature. The second to emerge is known as the limbic and is made up of a group of structures which serve to evaluate sensory data quickly and trigger a motor response. In other words, assess a situation and prepare the body for either fight or flight. And finally, the third, the neocortex, which is the brain which sets humans apart. It is the neocortex that has allowed us to develop new levels of advanced behavior – particularly social behavior as well as allowing us to develop language and higher level consciousness.

As you will appreciate, the above explanation is an oversimplification of the structure and function of our brains. However, it is a necessary first step in establishing the significance of understanding what is happening inside our head as we trade, and why it is just as important as understanding what is going on in the market.

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For traders, the area of the brain which can cause so many problems lies in the limbic system and is known as the amygdala. This area is also often referred to as the brain’s fear center and is responsible for producing the fight or flight reaction. As the ‘fear center’ for the brain, the amygdala ensures we recognize and recall danger. It triggers our emotional fear responses by performing a ‘quick and dirty’ assessment of what is happening, and we respond even before we know it.

For example, if we are walking alone at night and we see a dark shadow, and perhaps hear an unexpected noise, our heart will start to race as fear begins to take hold and our body prepares to either run or stand and fight. At an earlier stage in our evolution, at a time when the local cats were more likely to be saber tooth tigers, it was those humans who reacted the fastest, and without thinking to such signals, who survived the longest.

So fear is there for a good reason. It is there to keep us safe and protect us and has ensured our survival. This automatic response is so powerful it is triggered even when there is no direct danger. Charles Darwin proved this in his study of human emotions. In one experiment he placed his face behind the thick glass of a puff adder’s enclosure and steeled himself to ignore the inevitable strike. However, when the adder did strike he jumped back, much to his own annoyance.

But, what does walking along a dark alley at night and Charles Darwin’s reaction to a caged puff adder has to do with trading? And the answer is, in both these scenarios it is the amygdala taking control and responding to a threat or perceived threat. For traders, the trigger could be the fear of a loss or even a sudden movement on a chart. Either can trigger the fight or flight response, and the amygdala sim-ply reacts in the way it has done for millennia, in an endeavor to keep us safe.

As traders, we should know that trading is primarily about managing risk in a universe that is perpetually uncertain, sometimes random and very often totally irrational. However, our brain simply does not like it and therefore re-acts accordingly, in an effort to keep us safe.