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The Psychology of Trading

By Kerry Given

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Published: 01Sep2009
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Perhaps the most critical characteristic shared by successful investors and traders is their psychological approach to the market. All forms of financial investments have foundational knowledge that is essential to success in that market. I am not suggesting that you can simply think the right way and trade stocks, commodities or any other market successfully. But you could be the world's foremost expert on the commodities market and still not be able to translate that knowledge into monetary success.

Two emotions, fear and greed, can be lethal to your financial success. Developing an unemotional, systematic approach to your trading and investments is crucial for success. The following ideas will help you control your emotions and improve your trading results.

Develop a Trading System

Many people approach the market in a very unsystematic fashion. One day they are buying blue chip stocks that pay dividends; the next day they are playing tips from their nephews on biotechnology start-ups. Develop a system that suits your personal style, risk tolerance, knowledge level, and time available to devote to this activity. Decide what market you will trade and exactly how you will trade. Simply saying I will buy and sell stocks is not a trading system. Write down your rules. For example, for a stock investor, what criteria will stocks meet for your consideration? At what price will you buy? Will you short stocks? Where will you set your stop loss price? How much will you invest in any single position? How much will you diversify among industry sectors? Will you rotate in and out of sectors as they fall out of favor with the markets? Wherever possible, back test your rules and ensure your system has a reasonable expectation of profitability.

Have a Written Plan for Every Trade

Before you buy that stock or option spread or other investment, you must make some critical decisions. Write down your answers to the following questions: Why do I think this is a good idea? At what price will I admit my idea is not working and close the trade? If appropriate for this trade, at what price will I make some adjustments to the position? At what price will I take my profits? The answers to these questions and others constitute your trading plan. Be sure you have a plan before you establish the trade.

Follow Your Plan

This may be the hardest aspect of trading you must master. Once you have your plan, you must have the discipline to follow the plan unemotionally. Don't allow yourself to rationalize how the stock is going to rebound or allow your ego to refuse to admit the mistake. When the stock price dips below your stop loss price, close the position.

Don't hope. Don't rationalize. Follow your plan.

Evaluate Your Results

Develop a routine of reviewing your trading results periodically. When I review my trades each month, I make an important distinction between my "losing trades" and my "bad trades". Bad trades result when I break my own rules for entering the trade or lack the discipline to follow the plan. Losing trades are those where I followed all of my rules, but the trade just didn't work out as planned. These losses are simply a "cost of doing business". It is critical to treat your investing as a business, not a hobby. In any business, there are necessary expenses to keep the business open. Trading losses are an expected, necessary part of any investment activity. Developing a trading system and following the individual trade plans ensure that your profitable trades will outweigh your losses.

This Isn't Gambling

A common misperception holds that investing is akin to gambling. In fact, when you closely analyze the actual trades of many investors, they are indeed gamblers. They are following tips and hunches, investing large amounts on expected turnarounds, anticipating mergers, betting on start-ups, and so on. But consider the business of gambling - not the gambler, but the casino. The casino establishes a game where the casino holds a statistical edge; depending on the game, that edge may be rather small, of the order of 1-2%. The casino owner knows that he may have a big winner today at one of the blackjack tables, but that doesn't concern him because he knows he has an edge. When averaged over all of the different players and games, and over the long term, the casino will come out ahead.

When you work hard to develop the knowledge of the market you are trading, develop a trading system, have a written plan for every trade, follow your plan with great discipline, and learn from your mistakes, you have positioned yourself as the casino owner, not one of the customers.

Kerry W. Given, Ph.D., aka Dr. Duke, has over twenty years of experience investing in the stock market and over seven years experience trading equity and index options. He has taken many classes on investing and trading through the years and has discovered first hand how difficult it can be to separate the financial facts from the marketing hype, myths, and get rich quick schemes. He can be reached at: ParkwoodCapitalLLC.com

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