A Brief Look at Trading Psychology. This is another great article about Forex Trading Psychology. As I have mentioned here before I am CONVINCED that if you can conquer the psychological demons, you will become a successful forex trader.

This article was written by Forex mentor pro member, Julian J

"The Moral is to the Physical as Three to One"
Napoleon Bonaparte

What Napoleon meant is that psychological factors count for 75% of victory in battle (there wasn't word for "psychology" then). I think that we can extend this axiom to many areas, including trading.

It seems to me that we should not be ever-questing for the perfect trading system, because it doesn't exist, but trying to attain a level of psychological mastery that allows us to trade successfully enough of the time to increase our financial gains.

Engineers have a saying that "The best is the enemy of the good enough." In other words you only need to make something work acceptably well and to tinker around trying to create something perfect is a waste of time and energy.

Awareness of Risks

The psychology of trading involves risks that are not just of financial loss. Our bodies are set up to enhance pleasure sensations and avoid unpleasant ones. Trading can produce both, so can become conditioning of a dangerous nature.

I am particularly talking about gambling addiction. Forex trading stimulates the nervous system in ways that are pathways to addictive behaviour - intermittent rewards and a belief in choice.

"Previous research has shown a reliable pattern of brain activity when humans receive monetary wins. In particular, a region called the striatum, near the centre of the brain, is a crucial component in a reward circuit that also responds to natural reinforcers like food and sexual stimuli, as well as drugs of abuse like cocaine.

In ongoing research, Dr Clark is measuring activity in this reward circuit as volunteers experience near-misses and choice effects during a gambling task.

Both near-misses and personal choice cause gamblers to play for longer and to place larger bets. Over time, these distorted perceptions of one’s chances of winning may precipitate ‘loss chasing’, where gamblers continue to play in an effort to recoup accumulating debts.

Loss chasing is one of the hallmarks of problem gambling, which actually bears much resemblance to drug addiction. Problem gamblers also experience cravings and symptoms of withdrawal when denied the opportunity to gamble." Dr Luke Clark, Department of Experimental Psychology, University of Cambridge.
The psychology of gambling

While we may believe that we are trading using skill to give us a market edge, I hope members will note from the above how close we come to the psychological rewards and pitfalls which could lead to, - here I coin a phrase - "Problem Trading." If you become addicted to the high of a "win" and then start chasing wins, with bigger stakes each time, you are starting to evidence maladaptive behaviour.

The good news is that being aware of the potential for this happening, we can make efforts to watch out for and break the cycle. Take time off. Don't obsessively check the charts every day. Do something physical.

Try to think of it as a job, not an all-consuming passion/obsession; which I think it is for some of our members and I can see how it could be for me too, as I have a somewhat addictive side to my personality. It is possible to manage maladaptive habits and learn new ways of approaching psychologically problematical areas. Awareness is the first step.

The Psychology of Success

What psychological factors do successful traders have in common? This area does not seem to have been studied sufficiently either quantitatively or qualitatively. However various papers have been summarised on the Market Psych website which give us some pointers:

Traders should have a low state of physical arousal to market stimuli
"In one study Andrew Lo and Dmitry Repin used psycho physiological equipment to measure heart rate, blood pressure, and skin conductance while traders performed real-time trading. They found that more experienced traders had less physiological reactivity to information surprises (Lo and Repin, 2002)."

Overconfidence is not necessarily a good characteristic

"In a now famous study, Terrence Odean and Brad Barber (1998) analysed 10,000 brokerage accounts at Schwab. They found that overconfident investors tend to sell their winning stocks too early and stay in underperforming stocks too long, leading to 3.5% annual under performance of the market.

The actual nature of overconfidence is still debated, and Odean and Barber's definition of overconfidence above may now be more reflective of other phenomena such as the disposition effect." Market Psychology Money and Investing Personality Tests

(The disposition effect is an anomaly discovered in behavioral finance. It relates to the tendency of investors to sell shares whose price has increased, while keeping assets that have dropped in value

[1]. Investors are less willing to recognize losses (which they would be forced to do if they sold assets which had fallen in value), but are more willing to recognize gains. ) Wikipedia.

Traders need a high level of self-discipline. This seems particularly so for FMP members who mostly appear to trade from home/office individually rather than in a physical trading environment.

It is very isolating trading alone, and that is perhaps one of the reasons behind the runaway success of the forum because it helps us have a feeling of community, even when we are in different countries and time zones.

Here is perhaps the most interesting theory from Market Psych, about self-awareness and "Emotional IQ":
"Self-awareness is an enhanced consciousness of one's own physical and emotional state. Additionally, self-aware individuals often have logical reasoning behind their choices and behaviour. Self-awareness is one of the key traits of individuals who have high "emotional intelligence."

Emotional intelligence (EQ) is associated with long-term success in most vocations, and it is more predictive of vocational success than IQ. Biais et al (2001) found that highly "self-monitoring" participants in an experimental financial market place more profitable orders than others.

It is rather interesting that this aligns with the forex trader folklore that the best traders aren't necessarily the most intelligent ones.

In conclusion

In terms of psychology we need to avoid maladaptive behaviours like gambling and overconfidence and strive to improve areas such as self-discipline and emotional intelligence, which will probably have a positive effect on other areas of our lives too.

Finally, Mark Douglas says, "The irony is, of course, that, on the surface, trading looks so simple, when in fact most people will find it to be the most difficult endeavour they ever undertake. Success will always seem so close, yet always so elusive. And this frustration will continue until the trader adapts to the conditions that exist in the trading environment by learning a new thinking methodology, one that works most effectively in that environment, and not what he thinks will work based on his cultural and social upbringing." (The Disciplined Trader P.33)

References:
The psychology of gambling
Brett Steenbarger Trading Psychology
Market Psychology Money and Investing Personality Tests

The Disciplined Trader by Mark Douglas (1990).