At a micro and macro level, supply and demand are the key drivers of the financial market. The price of a commodity, stock, or currency will go high when its demand is high. When there is an oversupply of the asset, its price will go down.
On the other hand, emotions are what leads people to buy, sell or hold on to assets. People who are convinced that the commodity prices will go high hold on to them while those who believe the prices will go low sell them.
Why do you need to deal with your emotions?
There are several reasons why you need to deal with your emotions when trading. For the most part, they will prevent you from making very harmful mistakes.
Avoid making losses
First, you need to deal with emotions to avoid making losses. Indeed, some trading mistakes can be solved by just solving your emotional status. For example, opening a trade to cover a large loss can lead to more losses.
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Let us make this clear: it is still impossible to avoid all losses in trading. In this case, we need to learn how to manage them.
Avoid stress and depression
You should deal with your emotions to avoid or reduce stress and depression when trading. As you know by now, the market is a brutal place, where people lose money all the time.
As such, when you are prepared mentally, you will be in a good place to avoid and even reduce stress as you trade.
Avoid revenge trading
Revenge trading is a process where a trader opens a trade with the goal of covering a major loss. It is one of the riskiest things you can do in the market since that trade is usually not researched well.
Therefore, when your emotions are at a good state, you will be in a good position to reduce this situation.
Peace of mind
Being in a good emotional state will help to ensure that you have peace of mind as you trade. Data suggests that people who have peace of mind do better than those who are troubled.
Therefore, there is a close correlation between emotional well-being and performance.
Maintain focus on your goals
Finally, being in a good place mentally will help you maintain a focus on your goals. As mentioned above, you will normally have peace of mind when trading.
Implications of trading with emotional challenges
There are several risks that emerge when you are trading when you are not in a good state of mind:
- Avoiding trading journal - You will find yourself trading without a trading journal in the market. This is risky since this document helps people trade well and maintain discipline.
- Opening and closing trades - Another risk is that you will often open and close trades without doing enough research and analysis.
- Influenced by current events - You will also be influenced by the current events and news (aka recency bias). You will also take part in the Fear of Missing Out (FOMO) in the market.
- Panic selling - Finally, it can lead to panic selling in the market. This is where you sell assets that have started falling.
- Invalidate your analysis: You set up a trading plan after studying the events and news of the day. But then the first trade goes wrong and you let your emotions rule you. What can happen? All your efforts and time spent on your analysis are thrown away because you can no longer follow your plan!
The importance of the emotional state of the market
Steven Nison, a leading expert from the New York Institute of Finance gave a very important illustration on how people use emotions to trade.
In the early 1990s, the soybeans belt region of Illinois experienced a long draught. Traders at the Chicago Board of Trade knew that the draught would reduce the supply of the soybeans and therefore increase its price. They went bullish. On a Wednesday afternoon, there were light showers and there was an immediate response in exchange. By market close, soybeans was 12% lower.
As a result of fear, the Chicago Board Options Exchange (CBOE) developed a gauge to measure the amount of fear or volatility in the market: the VIX.
CBOE Vix index
The VIX measures the nature or amount of fear among the traders which impacts the outcome of their trades.
For instance, when a big news is anticipated, there is usually a lot of emotions leading to a higher volatility index.
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For experienced traders, the volatile market are their best periods because of the increased price movements. However, for new inexperienced traders, this is usually the worst period of time to trade.
Why? Because they don’t have the skills of how to use trading tools such as: buy stop, buy limit, sell stop, and sell limit.
How (and why) to handle emotions
The first thing every trader needs to do when dealing with emotions is on the risk and reward. Quite often, a higher risk results to a higher return.
When a trader allocates capital in less risky assets such as bonds and ETFs, chances of them making huge losses are very little.
For day traders however, their desire is to make quick money. To be at peace therefore, you need to only trade with money you can afford to lose.
The rule is that you should use money that you don’t intend to use for a long time. In addition, it is important to remember that all traders, experienced and inexperienced make mistakes and lose money. You too will lose.
To better manage your emotions, We recommend that you conduct your own research by combining multiple technical indicators with fundamental indicators.
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This will help you in two ways. One, it will help you save money, which you could have spent by using the sell-side analysts. Second, it will help you come up with a solid trading plan. It will help you know what to buy or sell, what to avoid and when to buy, sell or hold.
In conducting the research, We believe that by having a good understanding of the entire global economic environment will help you a great deal in making good decisions.
Assume you are an oil trader. If you have a good understanding of the state of oil supply and the main oil suppliers, you will be at a good position to allocate capital efficiently.
As a trader, we also recommend that you have a good grasp of technical analysis. This is because technical analysis gives a trader a good picture of the emotional state of the trading players.
For instance, volume based technical indicators are very important in showing overbought and oversupplied positions.
Learn to walk away
A good strategy of dealing with emotions is learning to walk away. You should learn to walk away when you have made a good return and also when you have lost money.
Most successful traders are those who trade for a short duration of their day. They make money and are satisfied with it. They avoid greed at all costs.
After making money by shorting a currency pair, you will often be tempted to continue your short position. When a reversal happens, you will end up wiping all your gains.
On the other hand, when you lose money, it is advisable to close your trades for the day because your emotions will be directed towards recouping your gains. If you take this path, chances are high that you will end up losing all or a significant amount of your money.
Managing emotions is a key part of a trader's career, whether they are positive or negative. In fact, the proper psychological state can make the difference between generating profits or losing money in the markets, as we have seen.
But there is something else. We must also pay attention to the emotions that dominate the borader market, because these could generate a lot of uncertainty in stocks and other assets.
Therefore, sometime it is very important to walk away and do something else. This will make you a better trader. By following these tips, We believe that your trading life will change forever.
External useful resources
- Why You Must Control Your Emotions While Trading In The Stock Market - Forbes