Published On: Wed, Nov 7th, 2012

The Psychology of a Successful Trader

The best trading plan or system in the world will be of no use if the trader makes no effort to learn and understand the psychology of trading. A car is of no use if you don’t learn to drive. Personal discipline to follow your plan and execute buy and sell orders in accordance with the signals is crucial.  The moment you deviate is the moment you begin to “fly by the seat of your pants” and that will always end in tears. Always. If you don’t believe that, ask any commercial airline pilot if he/she ever ignores the flight plan when flying.

You need to know that investment market prices move in accordance with certain mathematical and mass psychological behavioural laws and patterns.  This has been established beyond doubt by some of the brightest scientific minds in the world. In addition all successful traders understand their own personal psychological and behavioural tendencies which, incidentally, are usually quite unhelpful when trading! That’s why personal discipline and a plan or system is critically important.

How to Eliminate Risk

The plan must be to reduce or at least eliminate risk.  Most people (at least at first) find it hard to accept that this is possible. After all, the share market is generally considered risky and the common reaction to any suggestion that we can eliminate risk is simply scoffed at and rejected.  If that’s how you feel right now, you are about to learn a shocking truth.

It is not difficult to eliminate risk when trading shares.  Indeed it is remarkably simple and easy when you know how.  There’s the key right  there – you must learn how from somebody who can show you.  Once you understand this it’s a revelation and your attitude and approach to shares will change forever.  Let me repeat: It is not difficult to eliminate risk when trading shares.

The first thing to do is to understand what the risk is if trading without knowing how to eliminate it.

Obviously it is the potential loss of your money.  Let’s take that idea to an extreme.  You buy a parcel of shares and they fall to zero. That happens.  An Australian company called ABC Learning springs to mind as a fairly recent example.  The shares went from about $10 to zero and the company went out of business.  Investors lost their hard earned.

Now think of driving a car with no brakes.  You’re roaring along like ABC was (at about $10) and all is well.  Suddenly you find yourself flying over the crest of a hill and see a steep descent immediately in front of you and there’s a sharp right hand turn in the distance at the bottom of the hill.  You immediately press the brake pedal and nothing happens.  The pedal goes all the way to the floor and still there’s nothing. Down the hill you go and you know the rest of this story.

Can you see the analogy with ABC Learning?  You need brakes that work and you need to know when to use  them.  It’s exactly the  same when trading. Exactly the same. Why oh why, please tell me why people never learn this.  It’s so childishly simple yet it continues to  elude  millions  of  otherwise  intelligent  and  educated   people  to  their  great  expense.

So how do you install brakes that work in your trading car and how do you know when to use them?  First, it begins with you and how you think.  Let me ask you a question or two if I may.  When you buy groceries do  you see the cost as a loss?  If not, then what is it? When you fill up the gas tank in your car do you see the cost  as a loss?  If not,  then what is it?  When you pay your phone bill do you see it as a loss?  If not, then what is it?

Let me suggest these are simply costs of living, costs of doing business.  You never think of them as losses. Nobody does.  Understand this and you understand how to eliminate risk (of loss) when trading.  The brakes on your trading car are called, strangely enough, “stop losses”.  Amazing as this may sound, that’s exactly what they do. They stop losses in their tracks.

Here’s the procedure.  When you enter a trade  (shares, currencies or commodities  –  it’s all the same) you immediately draw a line on your chart that is your stop loss.  Let’s assume you are buying because your trading plan has pinpointed a sharp rise is imminent. Sometimes this signal fails.  That’s a fact of trading life and you need to have your brakes ready for use whenever this happens.  The stop loss is therefore placed not far from your entry price – often between 5% and 10% away.

Now let’s assume the price moves down and closes (the last trade of the day at the exchange is the closing price) below your stop loss line.  That’s your signal to apply the brakes and you do that by selling out next morning when the market opens.  This means you sell at a  small cost.  It’s a cost that you must be prepared to pay on some occasions if you are to trade at all.  Now I hope you can see  the reason for the questions about the cost of living above.  A stop loss is the equivalent of the brakes on your car, and when you need to use it, there is a small loss which is really nothing more than a cost associated with the activity of trading in the same way that your grocery bill is a small loss that is really a cost associated with the activity of living.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.