TradeInflection: The 5 Elements of Trading
Technical Analysis
What Is Technical Analysis?
Technical analysis is a trading discipline employed to evaluate investments or financial instruments to identify trading opportunities by analyzing statistical trends gathered from trading activity, such as price movement and volume. Unlike fundamental analysts, who attempt to evaluate a security's intrinsic value, technical analysts focus on patterns of price movements, trading signals and various other analytical charting tools to evaluate a security's strength or weakness.
Technical analysis can be used on any instrument with historical trading data. This includes stocks, futures, commodities, fixed-income, currencies, and other securities. In fact, technical analysis is far more prevalent in futures, commodities and the forex markets where traders focus on short-term price movements. Technical analysis focuses primarily on the analysis of charts. In recent years technical analysis has gained in popularity not only because of its simplicity but also its universal approach; meaning that it can be applied to all market segments and to different time intervals. Additionally, technical analysis is a method of market analysis that does not require an in-depth knowledge of finance. In order to understand what technical analysis is based on, it’s important to understand the three principles of technical analysis:
The three golden rules of technical analysis:
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The market discounts everything
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Prices move in trends
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History repeats itself
The market discounts everything - Technical analysts do not focus on macroeconomic and political events, as they believe that any events occurring around the world will be factored in the price of the instruments themselves. Of course, an event - such a natural disaster or geopolitical tensions - may affect a certain market, but a technical analyst is not interested in the reason. Rather, technical analysis focuses on the chart itself and the shapes, patterns and formations occurring on the chart.
Prices move in trends - Technical analysts believe that there is a bigger probability that a certain market movement may continue rather than reverse its direction. In other words, technical analysts believe that prices follow trends. What this means is that if trading is highly based on probability then in order to increase the probability of the success of a trade, traders should try to trade in the direction of the trend.
History repeats itself - One of the most popular methods of technical analysis is based on the notion that history repeats itself. What this means is that charts tend to form shapes that have occurred historically and the analysis of past patterns helps technical analysts in predicting future market movements. This principle focuses on the technical analyst’s belief that trading is highly connected with probability and the analysis of historical shapes provides the analyst with an edge before opening a trade. These shapes are known as price patterns.
Position Management
There are many facets to being a successful trader. One element that tends to be neglected by aspiring traders is the concept of position management. Position management is a combination of observation and action. A trader must observe the price action in both the market and their instrument to determine whether or not to take action on an open position at any given moment.
A trader should consistently be asking themselves the following questions:
1) Where should I take profits if the trade is working?
2) Where should I take losses if the trade is not working?
3) Where should I add to a (winning) position?
4) Where should I get completely flat?
Some may think that a trader should have considered all of the above prior to initiating a position. They would be correct. But the difference between having a detailed trading plan and managing a position is a function of time. When you establish a detailed trading plan prior to entering a new position you are only able to consider that which has already occurred. Once a position is opened there is a lot more information to be gathered.
Risk Management
Risk management helps cut down losses. It can also help protect a trader's account from losing all of his or her money. The risk occurs when the trader suffers a loss. If it can be managed it, the trader can open him or herself up to making money in the market. It is an essential but often overlooked prerequisite to successful active trading. You could be the most talented trader in the world with a natural eye for investment opportunities, and still blow your account with one bad call without proper risk management. No matter how good you are, or how experienced you are, you’re still going to incur losses. Even the best traders in the world suffer losing trades - it’s part and parcel of trading. That’s why risk management is so important to your trading.
Risk management rules are easy to grasp - even for beginners - but they can be challenging to actually follow, because all sorts of emotions are involved when real money is on the line. More later on this in the Psychology section.
A winning strategy normally consists of three crucial elements:
A trading system with an edge - This entails consistent application of the rules which govern a particular strategy, such as specific entry and exit points or always trading in the direction of the prevailing trend. Whatever it is, your trading strategy needs to be unique to you - after all, you’re the one using it - and then applied to your trades. Obviously at TradeInflection I have my own strategy that I teach involving Bollinger Bands, Pivot Points, Camarilla, RSI, Fibonacci Levels & Ichimoku with a dose of orderflow. This gives me an ability to determine a confluence of support and resistance levels during the day to trade higher probability setups.
Controlling your emotions - If you’ve tested your strategy on both a demo and a real account, you may notice a difference in results. This is because when real funds are involved, psychology plays a key part. Emotions like fear, greed, or excitement can stop you from sticking to your plan, creating potentially negative results. As a general rule, it’s considered good practice to let your profits run and cut your losses early. Keeping your emotions in check and sticking to your trading plan can help with this. This is easier said than done or indeed practised.
Money management - It's a crucial part of your strategy that specifies the size of the position, the amount of leverage used and any stop losses and take profit levels. Good money management is a vital part of trading successfully on the long term. It helps to maximise any profits while minimising any losses. It also prevents you from taking too much risk.
As you can see, proper consideration of these elements will play a strong role in your ability to trade successfully. If you’re only using two out of three elements above, sooner or later you may experience a setback that could have been avoided. One of the keys to trading is staying ‘alive’ for as long as you can.
The below are some techniques that can help control your risk:
The size of your position
Hedging - taking multiple positions at once in opposing markets (not for beginners)
Trading during certain hours
Stop Losses and Take Profit levels
Knowing when to take losses
Managing the Risk
One way that you could strike the right balance between reward and risk is to stick to a reward:risk ratio such as 2:1 or even 3:1, where your targeted profits are always double that of your maximum losses. So even if you suffer three losing trades, you’ll only need two profitable ones to ensure your total profits outnumber your losses if you stick to this reward:risk ratio. Although it’s not a general rule to follow, it can help you to visualise a specific approach to risk management.
Timing
Day trading is a game of prediction, and like anything involving prediction, timing matters. Timing is one of the main factors that separates a good trade from a bad trade. Furthermore, timing will determine the profitability of your hypothesis. You can be “right” and still lose money if your timing is off.
Trading always comes down to timing. To truly appreciate this, we simply need to note that one of the biggest gains in stock market history occurred on Oct. 19, 1987, during the day of its greatest crash. On that day, stocks had declined a harrowing 23% by the end of the day, but at around 1:30 p.m., they staged a massive rally that saw the Dow Jones and S&P 500 indexes verticalize off the bottom, rising more than 10% before running out of steam and turning down to end the day on the lows.
While most traders that day lost money, those who bought that bottom at 1:30 p.m. and sold their positions an hour later were rewarded with some of the best short-term gains in stock market history. Conversely, traders unfortunate enough to have shorted at 1:30 p.m. only to cover in panic an hour later held the dubious distinction of losing money on their shorts during the day of stock market's greatest decline.
If nothing else, the stock market crash of 1987 proved that trading is all about timing.
Timing is a vital ingredient to successful trading, but traders can still achieve profitability even if they are poor timers. In any market, the key to success lies with taking small positions using low leverage (low and wide) so that ill-timed trades can have plenty of room to absorb any adverse price action. To be sure, trading without stops is never a wise strategy. That is why even poor timers should adopt a probative approach that methodically keeps trading losses to a minimum while allowing the trader to continuously re-establish the position.
Timing is hard to master, but you can still capture significant gains on an ill-timed trade if you follow a few simple rules.
Rule #1: Define the Timeframe for Your Trade
Diligent traders think about entries and exits before they enter a trade, however many neglect the timeframe of the trade.
It’s important to define a timeframe for a trade before you enter a position. This is how you avoid turning a day trade into a swing trade into an account annihilator. Without a defined timeframe, it’s easy to become a bag holder.
Rule #2: Define Your Risk Tolerance
Once you’ve defined your timeframe, you need to define your risk tolerance. This is where you answer the question, “how wrong are you willing to be before you’re proven right?”
There’s no right answer. The key is going in with a plan. Regardless of how confident you are in your hypothesis, you need a failsafe; a point where you recognize that protecting your capital is more important than being right.
Rule #3: Time Your Entries and Exits
Once you have a hypothesis with a defined timeframe and risk threshold, it’s time to execute.
Your entries and exits will ultimately determine the profitability of your trades.
Take the following graph as an example:
A trader may accurately predict a breakout i.e. being “right”, but the entries and exits will ultimately determine the quality of the trade.
Psychology
Trading psychology refers to the emotions and mental state that help to dictate success or failure in trading. Trading psychology represents various aspects of an individual’s character and behaviours that influence their trading actions. Trading psychology can be as important if not the most important skill set to master as other attributes such as knowledge, experience and skill in determining trading success. Trading psychology can be associated with a few specific emotions and behaviours that are often catalysts for market trading. Conventional characterizations of emotionally-driven behaviour in markets ascribe most emotional trading to either greed or fear but this is too simplistic.
Setting Rules
To get their heads in the right place before they feel the psychological crunch, traders need to create rules. They should lay out guidelines based on their risk-reward tolerance for when they will enter a trade and exit it—whether through a profit target or stop loss—to take emotion out of the equation. Additionally, a trader might decide that in the wake of certain developments, such as specific positive or negative earnings or macroeconomic news, he or she will buy or sell a security.
Traders would also be wise to consider setting limits on the amount they are willing to win or lose in a day. If the profit target is hit, they take the money and run, and if losing trades hit a predetermined limit, they fold up their tent and go home, preventing further losses and living to trade another day.
How does psychology impact trading? There are 4 factors that can influence financial decisions – personality, emotions and moods, biases and social pressures.
Behavioural Biases
Behavioural biases are subconscious but systematic ways of thinking that can occur when the brain makes a mental shortcut. Biases can impact the way traders make and implement decisions. There are 6 biases that can influence traders: availability bias, anchoring bias, hindsight bias, confirmation bias, loss aversion bias and gambler's fallacy.
Availability bias
How does 'availability bias' affect traders?
Availability bias is the tendency to open or close positions based on information that is easily available, rather than sources that are more difficult to find. It can cause traders to act on false or unverified information, which can lead to higher levels of risk and loss.
Traders tend to lean towards what is personally most relevant, recent or emotional, even long after the event is over. The mind can take a shortcut based on examples that come to mind immediately, rather than on research and analysis. For example, if a person has a family member who recently lost money on a bitcoin trade, they may be less inclined to speculate on the cryptocurrency because it is hard for them to imagine that the market can be profitable.
In fact, a study by Moradia, Meshkib and Mostafaei found that there is a strong correlation between judgement and data availability. By surveying investors of stocks listed on the Tehran Stock Exchange, the researchers concluded that decision-making would likely improve as the amount of information released to the public increased.
How can traders prevent availability bias? - The most common way to prevent availability bias is to conduct extensive research and analysis i.e. Plan and do your own research.
Fundamental analysis is used to examine internal and external factors such as earnings reports, how the sector is performing, and the health of the economy, while technical analysis looks at historic price data and indicators to establish key entry and exit levels for each trade.
If you don't feel confident enough to trade on live markets, you could test your strategy on a demo account first. This enables you to practise trading with indicators and test your strategy in a risk-free environment using virtual funds.
Anchoring bias
What is anchoring bias in trading?
Anchoring bias is the tendency for traders to allow an initial piece of information to have a disproportionate influence on future decisions, regardless of its relevance.
For example, research by Kaustia, Alho and Puttonen showed that individual's estimates of stock returns were significantly influenced by the starting value they were given – the 'anchor'. When participants were given a high historical stock return, they were more likely to estimate that the future return would also be high, while a group given a lower initial value had far lower estimates.
Anchoring bias can have dangerous consequences in trading, as it might mean that a trader holds on to an asset far longer than they should do, or that they make an inaccurate assessment of an asset's worth based on the anchor value.
How can traders prevent anchoring bias? The best way to prevent anchoring bias in trading is by performing comprehensive research and analysis of the market to identify your own anchor.
Hindsight bias
How does hindsight bias affect traders?
Hindsight bias in trading is the tendency for individuals to express that they 'knew it all along', once they know the answer to a question or the outcome of an event that was previously uncertain.
The consequence of hindsight bias is that it often leads to a false sense of confidence. Most traders believe that they are very disciplined when trading – however, this is a dangerous mindset because biases can creep in and lead to irrational trading decisions.
A study by Biais and Weber found that those who exhibited the hindsight bias failed to remember how uncertain they had really been before they made their decisions. This means that they may have been inefficient in making choices regarding risk management. From the 85 investment bankers surveyed, all were found to exhibit hindsight bias.
How can traders prevent hindsight bias? One way to minimise the impact of hindsight bias is by keeping a trading diary. A trading diary is used to record your progress, keep track of your trading, and plan and refine your strategies. You should also use it to make a note of how you feel before, during and after each trade. By writing down whether you feel confident, afraid, hopeful or uncertain, you will be better placed to get a sense of when you were successful.
By mapping the reasons behind trading decisions and comparing them to the desired outcomes, you can use your past trades to inform your future strategy. So, instead of trying to make sense of what happened by oversimplifying the reasons for past events, you can learn from the outcome.
Confirmation bias
Confirmation bias is the tendency for traders to search for, and put greater weight behind, information that confirms their pre-existing beliefs or predictions. This could mean that a trader disregards negative news about an asset because they believe that the good outweighs the bad – even though this may not be the case.
Confirmation bias is linked to overconfidence, which can lead to poor decision-making and overtrading. A study by Park, Bin Gu, Kumar and Raghunathan found that traders with stronger confirmation bias are likely to exhibit greater levels of overconfidence and trade more frequently. This can lead to them obtaining lower profits because they might lose more often.
How can traders prevent confirmation bias? Confirmation bias can be prevented by carrying out your own analysis – whether this is technical or fundamental – and trusting that it is correct, even if it clashes with earlier predictions or preconceptions.
Technical and fundamental analysis can be a great way for you to identify whether you should be buying or selling a particular instrument – for example, overvalued stocks or undervalued stock. Analysis can confirm the true value of an asset in a more accurate and definitive way when compared to say, preconceived biases or gut feelings.
It could even benefit you to actively seek out information that clashes with your preconceptions because this could counteract your confirmation bias – forcing you to think about each trade in terms of its own merits.
Loss aversion bias
Loss aversion bias is a preference for avoiding losses over acquiring the equivalent gains. It implies that the fear of a loss is greater than the pleasure of a gain.
Research by Odean looked at 10,000 trading accounts held between 1987 to 1993, and found that individuals have a tendency to hold on to losing positions for a much longer period of time than winning trades, out of a fear of realising a loss.
Most traders close over 50% of trades at a gain, they lose significantly more on their losing trades than they make on their winning ones. This emphasises that instead of accepting a small loss, many traders will hold on to their positions and risk eroding their profits.
How can traders prevent loss aversion bias? A key step in preventing loss aversion bias is acknowledging that it exists. When you start to create a trading plan, it is important to consider how much you are willing to lose as well as how much you want to gain. And once you have established your trading plan, it is important that you have the discipline to stick to it to avoid taking unnecessary losses.
One way of doing this is by setting a suitable risk-to-reward ratio, which compares your capital at risk to the amount you stand to gain. For example, if you set a ratio of 1:3, then you'd only need to profit on three out of ten trades to have an overall profit. The correct risk-to-reward ratio could ensure that your gains are always at least as large as any potential losses, giving you the confidence to overcome loss aversion bias.
Gambler's fallacy
How can 'gambler's fallacy' affect traders?
Gambler's fallacy in trading is the tendency of an individual to think that a trade will go a certain way based on past events – even though there is no substantive evidence to support the trader's thinking. The term originated from the inclination of gamblers to think that a bet might go a certain way based on previous results.
When applied to trading, a study by Rakesh found that 55% of investors who took part believed that a random event would occur again just because it had occurred in the past. This could cause a trader to base a decision on previous analysis, even when the indicators which had worked for them in the past are no longer relevant or helpful given the current market movements.
How can traders prevent gambler's fallacy? You can minimise the risk of gambler's fallacy affecting your trading by basing your decisions on up-to-date analysis and setting a clear risk-to-reward ratio – which compares the potential loss to the potential gain for each trade you open. This can help you to think clearly and assess each situation on its own merits, and will also minimise the effects of any losses on the overall value of your trading account.
Emotions and Moods
Emotions are chemical changes in the nervous system that cause an instant reaction to an event, while moods are a by-product of our emotions that can last for a lot longer. The emotional state of a trader can have a significant influence over the way they react to certain circumstances and triggers. Understand the psychology of fear, greed, hope, frustration and boredom, and the impact they can have on a trader's performance.
Fear
What does 'fear' mean in trading?
Fear in trading is the distress caused by the threat of loss, real or imagined. Fear can help to keep impulsivity in check but it can also cloud decision making, causing a trader to close out a position too early, or miss out on a profit by being too afraid to open a trade.
Research by Lee and Andrade has found that when fear was induced in a group of traders – by showing them clips from horror movies – only 55% of participants wanted to hold on to their positions. This contrasted with a control group in which fear was not induced, where 75% of the traders still held onto their positions.
Most retail traders are more affected by fear and uncertainty when compared to professional traders. One explanation for this is that professional traders might have experienced more losses than traders who are just starting out, and so could be more comfortable with the risk of loss to secure a profit.
Equally, more experienced traders might have more discipline, meaning they recognise the benefits of closing a losing trade, rather than letting it run.
How can traders limit the effects of fear? One way to limit the effects of fear is by approaching every trade with a plan, and by placing stops to reduce any losses and limits to lock in profits. If you have carried out sufficient technical and fundamental analysis before you open a position, and if your stop or limit is placed at the correct level, you should be confident in the fact that you have done everything in your power to prevent unnecessary losses.
Technical analysis is a great way for you to identify the best levels at which to place a stop or a limit. One form of technical analysis which enables you to do this is a Fibonacci retracement, which you can use to highlight levels of support and resistance.
Greed
What does 'greed' mean in trading?
Greed in trading is the impulse to act in irrational ways in pursuit of excessive gain. It manifests itself when a trader gets over enthusiastic and trades beyond their means – opening more positions than usual or holding on to positions for too long because they are chasing an even greater gain. In doing so, they might incur a heavy loss and may even wipe out the profit they have already made.
Greed has a lot to do with how often an individual trades, or equally, if a trader thinks that they should be trading more. A study by Graham, Harvey and Huang found that, when measuring a trader's confidence levels, a small gain in their confidence levels resulted in a similar increase in their trading frequency
However, while traders might feel confident enough in their abilities to trade more, research by Park, Bin Gu, Kumar and Raghunathan has found that those who trade more often might actually achieve lower realised returns.
How can traders prevent greed? You can prevent greed from affecting your positions by becoming familiar with risk management strategies. Risk management strategies can help you to understand the risks associated with trading with leverage and why you shouldn't overexpose yourself to the markets. One of the most effective ways to manage risk is to use a risk-to-reward ratio, which compares the potential loss to the potential gain for each trade you open.
Hope
What does 'hope' mean in trading?
Hope in trading is a feeling of expectation and is often linked to optimism, confidence or experience. While all traders need to have some hope when they open positions, there can be downsides of excessive optimism. For example, a trader might hold on to a losing trade because they believe that it will reverse its trend and become profitable.
A study by Nofsinger revealed that traders find it difficult to cut losses because they view it as an admission of defeat. Traders hope that the asset will recover so they won't have to face the realisation that it may have been a bad decision to open the position. Hope can also determine how frequently an individual trades and how much they risk. For example, Germain, Rousseau and Van state that 'optimistic traders purchase more or sell smaller quantities, whereas pessimistic traders sell more or purchase smaller quantities than if they were realistic.'
How can traders prevent hope from impacting their decisions? One way you can prevent hope from impacting your decisions is to set out a number of goals – possibly in a trading log or diary – for your time on the markets. By setting goals, you know exactly what you should be hoping for from your trading, which means that you could be less inclined to let losses run out of frustration.
Equally, a set of goals can help to manage expectations, so you could be more inclined to be happy with what you have earned. This could prevent greed getting the better of you and stop you from opening new trades in the hope of earning more.
Frustration
What does 'frustration' mean in trading?
Frustration in trading is the annoyance traders feel when the markets have behaved in a way that they didn't anticipate. The largest cause of frustration is loss, but it could also be that a trader didn't gain as much profit as they thought they would.
The time of day at which a trader incurs a loss, or a series of losses, can have a big impact on how frustrated they feel. Research by Coval and Shumway shows that traders who experience morning losses are about 16% more likely to assume above-average afternoon risk than traders with morning gains.
Most inexperienced traders are more highly impacted by negative emotions than experienced traders – meaning that they might be more affected by the frustration caused by losses.
How can traders prevent frustration? Frustration can be prevented by understanding that you will almost certainly incur losses during your time on the markets. The important thing to remember is that losses can be managed by attaching stops and limits to your trades.
Stops will restrict your losses, while limits will lock in your profits at a level which you see as favourable. As a result, stops and limits can help to take the decision about whether to close a trade out of your hands – so you could be less inclined to let your losses run out of frustration, or in the hope of eventual profits.
Boredom
What does 'boredom' mean in trading?
Boredom in trading is the tendency for traders to get fed-up with the financial markets and feel that their routines have become monotonous. This can cause a trader to deviate from their plan and take unnecessary risks to try and stir up some excitement.
Boredom might arise if the markets are moving slowly, or if a trader hasn't profited as much as they thought they would. As a result, a trader might start sensation seeking to combat boredom – searching for varied, novel, complex, and intense sensations and experiences.
However, this can lead to excessive risk taking. Wong and Carducci carried out research in which they devised a 'sensation seeking scale' (SSS) to show how susceptible participants were to sensation seeking and unnecessary risk taking due to boredom. On the SSS, male participants were more susceptible to sensation seeking and boredom than their female counterparts.
How can traders prevent boredom? The effects of boredom can be prevented by using a demo account to create and test new strategies in a risk-free environment. This could be beneficial if you are fed up with your current trading methods and want to try something new.
Personality
Personality is the combination of characteristics that make up each trader's distinct identity. The features of a trader's personality will predispose them to certain financial behaviours, determine how they will perform and their susceptibility to other psychological influences. There are 5 five key areas of personality: discipline, decisiveness, patience, rationality and confidence.
Discipline
What does 'discipline' mean in trading?
Discipline in trading is the practice of sticking to strategies, avoiding holding onto losing trades and taking profit at the right time. It is an attribute that regulates attention, emotional responses and decision making.
Without discipline, traders risk letting their emotions cloud their judgement, which could lead to large losses. In fact, a study by Lock and Mann found that the median holding time for losses is over four times as long as the holding time for gains, and this lack of discipline makes a trader less likely to be successful in the future.
How can traders become disciplined? The best way to become disciplined is by creating a trading plan and outlining a risk-to-reward ratio – this compares the amount of money you are risking to the potential gain to your position. In theory, with the right ratio, you could lose more than you win, and still make a profit. For example, if your ratio was 1:3, you would only need to be successful on three out of ten trades to have an overall profit.
Patience
What is 'patience' in trading?
Patience is the ability of a trader to wait for signals that indicate that it is time to enter or exit the market. This could include making decisions that delay instant gratification in the hope of a future benefit.
A study by Freeman-Shor found that only 21% of the stock investments analysed realised a return of over 100%, even though many of the shares went up by significantly more over time. This was because very few individuals had the patience to wait for the trend to run, preferring to sell for a much smaller profit than risk losing what they had made.
Although it is unreasonable for traders to expect huge returns from every trade, it is important not to 'snatch profits' in small amounts out of fear or loss aversion. Although this might give a sense of instant gratification, there is the risk of losing out on a much larger gain.
How can traders become patient? To develop patience, it is important to understand that your desired market movement might not happen straight away or at all. Building a suitable risk management strategy is a great way of managing impatience – this should include setting stop-losses and limit orders.
For example, a trailing stop-loss will automatically follow your position by a certain amount of points. This enables you to lock in your profit if the market moves in your favour, but it will remain in place if the market falls – closing out your position if the market moves against you.
Decisiveness
What does 'decisiveness' mean in trading?
Decisiveness in trading is the ability to identify opportunities and act efficiently – this includes making decisions about when to enter and exit trades, assimilating new information into a plan and learning from mistakes.
However, research by Gollwitzer showed that ill-informed decisions can lead to excessive risk, because they cause a disparity between a plan and its execution. Although it is important to act quickly, it is also important to make sure you have taken all the available information into account to give yourself the best chance of making rational decisions.
How can traders become decisive? The best way to become decisive is to create a suitable trading strategy that outlines what you will need to see in your technical and fundamental analysis before you open a trade. This enables you to identify suitable entry and exit points before you start trading and ensures that your decisions have a solid foundation in historical data and trends, rather than 'gut feeling'.
If you focus on technical analysis, you'll use indicators to study signals and trends. The data they give off is then used to establish entry and exit points, and where to place stops and limits. Popular technical analysis tools include Fibonacci retracements, moving averages and Bollinger bands. If you choose to use fundamental analysis, you'll evaluate macroeconomic data, company financial reports and the news to establish how and when to trade.
Rationality
What is 'rationality' in trading?
Rationality in trading is the ability to make choices that will result in the best possible outcome given the information available. Rational decisions aim to maximise an advantage, while minimising any losses.
Although rationality is all about seeking the optimal outcome, studies have been quick to point out that this doesn't always mean making money – a rational decision can involve minimising losses and even accepting a loss.
How can traders become rational? A common way to improve rational decision-making is through a demo account, which enables you to practise trading and test your strategy without risking any capital.
If you aren't confident in your ability to stick to your pre-made decisions, you could consider automating your trading strategy. This is where you would set the parameters of your order and allow an algorithm to analyse the market and respond to opportunities as they arise.
Confidence
What is confidence in trading?
Confidence in trading is trust in one's own abilities and knowledge. Every trader requires a certain level of confidence so that they can identify and act on opportunities, as well as bounce back after a losing streak.
However, there is a difference between confidence and overconfidence, which is an unrealistic view of one's abilities. Research by Dorn and Huberman found that, of the 1345 German investors they surveyed, those who considered themselves more knowledgeable than average were actually more prone to excessively buy and sell assets. This habit can lead to further losses and decisions that are based on fear rather than research.
All traders will experience losses, but a confident trader will know that everyone has bad days and that sets them apart is learning how to minimise these losses.
How can traders become confident? The best way to become a confident trader is by trading using a demo account, which enables you to test your trading strategy in a risk-free environment using virtual funds. Alternatively, you could opt to backtest your trading strategy by taking a chunk of real data from a selection of markets and running your strategy against it.
Both methods enable you to build up confidence in how your strategy would perform, without using any actual capital. However, it's important to remember that neither provides a perfect reflection of a live market, as they won't always take factors such as liquidity into account when executing your trades.
To avoid being overconfident, just remember that there is never an end to how much you can learn and the experience you can develop. Even the most successful traders can learn more and develop their strategy further.
Social pressures
Social pressures are external factors that can have a direct influence on a trader's psychology, encouraging them to change their attitudes, values and behaviours. The social pressure to perform in a certain way can cause errors and lead to traders taking on greater amounts of risk. Discover the impact of herding, rumours, news and competition on trader's behaviour.
Herding
What does 'herding' mean in trading?
Herding in trading is the tendency for traders to follow others without doing their own research and analysis. They will observe that there is a trend among other traders, and then feel the pressure to jump on the bandwagon, even when there is no clear reason for them to do so.
A herd is often driven by fear and greed, as traders don't want to miss out on opportunities that others are taking. However, basing decisions on herds can lead to information processing errors and inhibits learning.
Research by Kremer and Nautz stated that herding can lead to bubbles and crashes if trades are not based on analysis. An example of herding can be seen in the 1990s to 2000s dotcom bubble. Traders were all buying into the market, because 'everyone was doing it', but then the bubble burst and many people suffered severe financial consequences.
How can traders prevent herding? The first step to preventing herding is to make decisions based on your own trading plan and research.
Although social trading is becoming increasingly popular, it's important to be mindful of your personal plan, and not just do what others are doing for the sake of it. This is why many traders set SMART goals to keep themselves focused; these are goals that are specific, measurable, attainable, relevant and time-bound.
Remember, financial markets can be unpredictable – so it is important to stay aware and do your own research.
Rumours
How do 'rumours' affect traders?
Rumours in trading are any type of unverified claim that can influence traders' decisions. Rumours can cause traders to make mistakes by influencing them to enter and exit positions based on fear and greed rather than fact.
Rumours can be favourable or unfavourable towards a financial asset, which can cause traders to either buy the asset or sell it prematurely. For example, in 2002 there was a rumour that United Airlines was entering bankruptcy, which caused the company to lose 73% of its market capitalisation. However, this rumour was false. A study by Marshall found that although participants were aware of the false information, they held their positions for twice as long as expected.
How can traders avoid rumours? It's impossible to avoid rumours or fake news completely – they're everywhere, but traders can control how they react to them. Markets can become extremely volatile when a rumour is spread so it is important that traders remain as rational as possible, and always consider the risks when trading.
Rumours that are widely reported can have their place in fundamental analysis, but you should always assess the source and reliability of the rumour carefully, before factoring it in. This should never be done without a risk management strategy in place. With a risk management plan, you can set stops and limits to prevent larger-than-expected losses, as well as trading alerts that give you a choice of whether to act or not.
News
How can the 'news' affect traders?
The news can put pressure on traders to make certain decisions and interpret information in a particular way. News is a crucial part of information gathering, but it's important for traders to interpret the news objectively.
Forythe, Nelson, Neumann and Wright studied 192 traders' opinions on US elections and found that the individuals who dispassionately interpreted the news, and resisted confirmation bias, were more likely to make a profit. In contrast, those who traded the news and exhibited availability bias became overconfident and this increased their risk.
How can traders use financial news? Using financial news is a great way to stay abreast of changes in the market and to help you fine-tune your strategy, but it is important not to become over-reliant on one source as this can create a narrow view of the market.
Fundamental analysis is a common way of gathering information. It is the use of various internal and external factors – like news, macroeconomic data and company announcements – to decide how much a particular asset is worth. However, it is also important to use technical analysis too. This can help you predict the future direction of a market's price, by studying historical chart patterns and formations. It involves applying technical indicators, such as Fibonacci retracements and moving averages, to identify price patterns and key levels.
Competition
How can 'competition' affect traders?
Competition is the pressure to make more money or place more trades than others. While trading is considered a competitive practice, traders should have the patience and discipline to follow their own trading rules and plan.
Competition can cause a trader to adopt bad habits – for example, a 'win at all costs' mentality, which could open them up to negative emotions and impulsive trading decisions. A study by Dijk has found that traders put up 50% more in a risky situation when peers would be aware of their decisions than when they were in an isolated individual setting.
Not only should traders be wary of competing against each other, they also shouldn't compete with themselves. By trying to beat a record or increase a profit every day, traders might be forcing themselves into trades that they wouldn't normally make.
How can traders avoid competition? To avoid competition, you can create a routine that is based on your trading plan and risk management strategy. One popular tool is a trading diary, which helps you keep record of your trades – including why you entered them, the expected profit, how you chose to minimise your market risk, your entry and exit points, and how the market behaved.
You should focus on yourself, as there is more potential in self-development and learning than in competing with others.
Sausages
So, after reading the above you will probably think well, I have received some new information or indeed if you have been around trading for sometime you may be aware of the above but not necessarily in the above format. The key to all the above and indeed ‘The 5 Elements of Trading’ is not in the understanding of it, it is the practice of it.
Sausages? At TradeInflection my methodology is in the practice or the art of trading with the ‘The 5 Elements of Trading’. Breaking down the elements in to Position Management, Technical Analysis, Risk Management, Timing and Psychology you can see the ability to change your habits involved in these elements requires studious application or to put it another way a plan! Without a plan, structure, routine whatever you wish to call it you are at the whims of your mind, emotions and the market which we all know can be very difficult and very dangerous.
This is where my favourite saying comes in “Sausages”. We all know sausages are made up of various parts and made by a process that is the same process over and over again, a recipe that does not change yet gives the same consistent results and can be produced on scale.
This is the methodology I like to apply to trading and continually teach my mentees. The same process, the same conditions, the same confluences, the same inputs and expecting the same results over an extended period of time. I teach this by breaking the down the ‘The 5 Elements of Trading’ into manageable bite size chunks that we work on over a 3-month period. I start with eliminating the mistakes by having a trading structure around both the strengths and weakness of the individual concerned. I then teach the trading strategy around using various tools and apply a ‘confluence technique’ that increases the probability of a trade. We then make this a routine which should deliver a higher probability of more winners than losers.The key to success is encompassing ‘The 5 Elements of Trading’ into your daily routine and making this habitual.
Habits
Without going into great detail relating to the psychology and science of habits. The formula I apply is to create new habits around trading to such an extent the old habits are discarded and the new ones created become the new norm.
What is a Habit
A habit is a routine of behaviour that is repeated regularly and tends to occur subconsciously. Habit formation is the process by which a behaviour, through regular repetition, becomes automatic or habitual. This is modelled as an increase in automaticity with number of repetitions up to an asymptote. This process of habit formation can be slow. Lally et al. (2010) found the average time for participants to reach the asymptote of automaticity was 66 days with a range of 18–254 days.
There are four main components to habit formation: the context cue, the craving, the behavioural repetition, and the reward. The context cue can be a prior action, time of day, location, or anything that triggers the habitual behaviour. This could be anything that one's mind associates with that habit and one will automatically let a habit come to the surface. The craving is the desire to perform the habit. The behaviour is the actual habit that one exhibits, and the reward, such as a positive feeling, therefore continues the "habit loop". A habit may initially be triggered by a goal, but over time that goal becomes less necessary and the habit becomes more automatic. Intermittent or uncertain rewards have been found to be particularly effective in promoting habit learning.
One of the best ways to build a new habit is to identify a current habit you already do each day and then stack your new behaviour on top. This is called habit stacking.
Habit stacking is a special form of an implementation intention. Rather than pairing your new habit with a particular time and location, you pair it with a current habit. This method, which was created by BJ Fogg as part of his Tiny Habits program, can be used to design an obvious cue for nearly any habit.
Habit Stacking Examples
The habit stacking formula is:
After/Before [CURRENT HABIT], I will [NEW HABIT]
For example:
After I pour my cup of coffee each morning, I will meditate for one minute.
After I take off my work shoes, I will immediately change into my workout clothes.
After I sit down to dinner, I will say one thing I’m grateful for that happened today.
After I get into bed at night, I will give my partner a kiss.
After I put on my running shoes, I will text a friend or family member where I am running and how long it will take.
Again, the reason habit stacking works so well is that your current habits are already built into your brain. You have patterns and behaviours that have been strengthened over years. By linking your new habits to a cycle that is already built into your brain, you make it more likely that you'll stick to the new behaviour.
Once you have mastered this basic structure, you can begin to create larger stacks by chaining small habits together. This allows you to take advantage of the natural momentum that comes from one behaviour leading into the next.
The below matrix is what I currently use in how to change trading behaviour.
Current habit behaviour
The above diagram illustrates the application of making a trade, what is not shown is the individuals bad or good habits associated with trading. Every individual has positive and negative aspects to their trading. The key is to change the bad habits by changing and stacking new behaviours into to a trading process that over time brings trading success and confidence.
I go through a 1-2-1 with the individual each week to assess if they have met their daily trading / process objectives and if necessary, we change the process thus creating a new habit.
The below two diagrams show in matrix form how a trader can insert new behaviours into his / her routine to minimise risk and optimise reward.
PSETS- Process, Set Up, Entry, Target, Stop - Trading Mind Set Matrix
And when the trade is live, we go from Process to Psychological
PSETS- Psychological, Set Up, Entry, Target, Stop - whilst trade is live
The above two diagrams show how a new a habit can be implemented and performed and allow the trader to make decisions based up on a predefined set of rules, objectives, goals whatever you want to call them. The key clearly is to have a set of rules defined and practice using them in a habitual structure both on expected and unexpected outcomes. Whilst all the above may not be exciting or increase your dopamine levels I can assure you it will bring both trading success and a sensible risk management strategy over the long term.
DISCLAIMER - There is a very high degree of risk involved in trading. Past results are not indicative of future returns. TradeInflection.com and all individuals affiliated with this site assume no responsibility for your trading and investment results. The indicators, strategies, columns, articles and all other features are for educational purposes only and should not be construed as investment advice.