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The Importance of Trading Psychology

Montréal Exchange
March 11, 2022
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The Importance of Trading Psychology

As a market strategist for over the past 13 years, I’ve corresponded and provided market color to thousands of retail and institutional investors. In this post, I wanted to share what I have consistently found to be a distinguishable factor that sets successful traders apart. The difference that divides professional traders is an important lesson for all investors that boils down to trading psychology. This specific mindset is what prevents professionals from chasing losing trades and blowing up their accounts. I’m sharing this to help investors realize how a small and simple change may spark a drastic change in stemming underperformance that many investors suffer from.

Trading Goes South

Every investor has experienced a trade where the trade, chart, and analysis just seemed to align perfectly. However, after entering the trade, it starts to move in the opposite direction. The next step you take is what sets successful traders apart.
With professionals, they simply shrug off the fact that they were wrong, cut their losses, and move onto the next trade. While on the other hand, many retail investors struggle with the challenge of being “wrong” and look for reasons to add more risk in an attempt to “get back to breakeven.” This is where most traders start to unravel with the first steps towards adding too much
risk and potentially blowing up a trading account on the account of “not wanting to be wrong.” Unfortunately, this psychological attachment to winning is what I have observed to cause most traders to blow up their accounts.

We are only human

We all have a natural inclination to want to win. No one likes to take a loss on a trade, but many people equate “losing” to taking a loss on a trade. This leads to a terrible habit of holding on to losing trades for too long or adding on to losing trades.
Many inexperienced traders would define winning as closing out a profitable trade every single time – an impossible feat. As a strategist who has worked with thousands of investors, I can tell you that an experienced investor can accurately call the directional outlook of an asset about 60-65% of the time. Yet, I hear many novice investors attempt to “win” 80-90% of trades, a near impossibility in the long run. To change one’s psychology for trading, we need to redefine what winning is in a trading account.

Redefining Success

So, what does it mean to “win” in trading? Ultimately, our goal as traders is to make a profit in the long run, winning or losing individual trades is somewhat irrelevant for the bigger picture. Once traders realize that losing is just a part of trading, and focuses on reducing losses, that is the psychological shift that sets professionals apart. As traders, we do not need to aim to profit from every trade or even a large percentage of trades. A trading strategy with only 50% winners is still an effective strategy if it produces larger profits than the 50% of losing trades. On the flip side, I can find countless traders who claim an 80% winrate but are losing money each year. Traders need to shift their mindset from winning, to focus on being disciplined on long term
profitability. This leads us to our next question, how does one focus on long term profitability?

Playing the Wrong Game

In 1986 James P. Carse wrote a book called Infinite vs. Finite Games. James was not a trader or a financial professional, yet this book redefined game theory and how we think about leadership, war, business, and countless other disciplines. A fantastic talk by Simon Sinek highlights how to apply this to succeed at leadership. The eye-opening lesson from this book is realizing what type of game an investment account is classified as. Finite games such as basketball or football have set rules, and a declared winner and loser at the end. While on the other hand, infinite games such as trading, owning a business, operating a casino are all “games” that have no set rules with no winners or losers, just players and those who drop out of the game. The revelation is that there is no such thing as “winning” in trading, only the investors who are still investing, and investors who have lost their money and have to drop out of trading. In this infinite game of investing, traders need to focus on maintaining a portfolio’s value, not each individual trade. Most investors are unsuccessful as traders simply due to a focus on winning each trade (a finite game) while risking their entire accounts just to “win.” Once an investor realizes that the game they are playing is infinite, and the sole focus should be on “staying in the game”, that is when a trader has the potential to succeed in trading.

The Golden Rule

With a clear understanding of the game, we shift our focus on long term profitability and “staying in” this infinite game of financial markets. The answer is astoundingly simple and rooted in the fundamentals of math. Never risk more than 1-2% of your entire account on any single trade. The primary shift in thinking for professionals is on risk, not reward. At all costs, one must prevent a trading account from blowing up (dropping out of the infinite game). Without running too deep into the math, it all comes down to the power of exponential functions. The % amount that is required to breakeven, grows at an exponential pace for every 1% loss in your trading account. The # of trades that are required to blow up an account, grow at an exponential pace for every 1% less you risk per trade. Simply due to these 2 functions that govern your trading accounts, you can reduce the risk of “blowing up your account” significantly by risking only 1-2% of your entire account per trade. Moreover, I’ve noticed that traders are less emotionally attached to small trades and less likely to chase a losing trade. When traders risk very large amounts, they tend to become emotionally attached and get into bigger trouble.

 

 

 

Summary

Psychology has a large effect on human behavior and many studies confirm biases that we have towards risk and reward. The more we understand this, the better we are with making adaptations and using rules to correct those biases. Fortunately, the rules for risk management to prevent your account from blowing up are surprisingly simple. However, investors must first learn to shift their focus away from winning towards risk management. Arguably this is the most difficult but important lesson for any investor to learn in order to succeed at trading. The finite vs. infinite game theory is simply a tool in helping investors inspire a change in thinking. Professionals have to first learn how to minimize portfolio losses above making money or winning, which is what keeps them in the game. A simple way to do this is by risking only 1%-2% of your account per trade. Even with a string of losing trades, you still have a large portion of your portfolio left to continue trading and staying in the game.

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Disclaimer:

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.

Copyright © 2022 Bourse de Montréal Inc. All rights reserved.  Do not copy, distribute, sell or modify this document without Bourse de Montréal Inc.’s prior written consent. This information is provided for information purposes only.  The views, opinions and advice provided in this article reflect those of the individual author.  Neither TMX Group Limited nor any of its affiliated companies guarantees the completeness of the information contained in this publication, and we are not responsible for any errors or omissions in or your use of, or reliance on, the information. This publication is not intended to provide legal, accounting, tax, investment, financial, or other advice and should not be relied upon for such advice. The information provided is not an invitation to purchase securities listed on Montreal Exchange, Toronto Stock Exchange, and/or TSX Venture Exchange. TMX Group and its affiliated companies do not endorse or recommend any securities referenced in this publication.  Montréal Exchange and MX  are the trademarks of Bourse de Montréal Inc.  TMX, the TMX design, The Future is Yours to See., and Voir le futur. Réaliser l’avenir. are the trademarks of TSX Inc. and are used under license.

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