Trading Psychology

6A.Neurofinance and emotions while trading:

Neurofinance is an emerging research about the influence of emotional intelligence in investment decisions.This research is also linked with behavioral finance to understand the psychology of the trader and what leads to market abnormalities.

Trading psychology eventually develops with more experience and knowledge but even in the essential stages makes up a huge part of trading. There are many times where the trading edge is very efficient, erroneous decisions are made due to fear, greed or improper risk management.

Some examples of such behavioral analysis are:

  • Herd behavior:

    The theory of herd behavior indicates that many traders tend to follow the crowd collectively for their own decisions. This is the reason for sudden market surges and crashes as well.

  • Emotional gap:

    Emotional gap refers to making decisions based on extreme emotions such as anger, greed or fear.
    For example: To cover up one loss a trader might engage in another trade to cover up all the loss can lead to more losses.

  • Loss aversion:

    Loss aversion suggests that the trader tends to put more of their focus on how to avoid and manage their losses than their gains. When a trader is profiting on a trade they often are unable to hold for the entire trend and might exit the position earlier but hold a loss making position beyond stop loss and for a longer time.

6B.Importance of Risk management:

  • Self risk profiling:
    ● Risk management:

    It helps a trader protect their capital in the long term and be profitable. Without proper risk management there will be a higher possibility of booking losses than profit. Hence, the trades need to be properly planned. The trader needs to be aware of their risk capacity and plan the trade accordingly. Before taking a trade, an individual should be aware of their risk tolerance, risk capacity and then decide the type of trader they want to be. Risk profiling can be done on the basis of conservative, moderate and aggressive risk takers.

    ● Aggressive risk takers:

    These investors are usually well aware of the risks and take long term trades without fearing the fluctuations. They are experienced and hence know their risk taking capacity as per trend.

    ● Moderate risk takers:

    These investors take less risk than aggressive investors and usually plan a certain percentage of risk that they can take as per capital. They try to balance investing between risky and safe assets.

    ● Conservative risk takers:

    These investors take the least risk amongst all and always go for safe investments such as Fixed deposits or equities. They are okay with minimum returns and minimum risk.

  • Risk-reward ratio:

    This ratio helps the trader to determine how much risk they can take as per the expected reward. This helps them to save capital and have more chances of being profitable.
    For example: If the risk to reward ratio is 1:1 then the trader expects the same amount of loss as the potential profit.

  • Position sizing:

    Position sizing refers to deciding the quantity to trade as per the risk appetite of the person. The amount invested in one trade should also be decided after carefully analyzing the possible risk and expected return, time duration associated with the position.
    For example: If a trader has a $50,000 trading account and wants to initiate a long position in Tesla at a price of $170 and decides to risk 2% of the capital i.e. $1000 (2% of $50,000) in every trade and his ideal risk reward is 1:1. If the trader expects the stock to move 10% in his favor, he could set a profit target of $187 and SL as $153.

    Based on these parameters, the trader could determine their position size as follows:

    ● Maximum risk per trade: $1000
    ● Stop loss level: $153
    ●Profit target: $187
    ● Risk per share: ($170-$153)= $17
    ● Position size: $1000 ÷ $17 =59 shares

    Therefore, the trader could open a position of 59 shares of Tesla, which would have a total value of $10030 (59 quantity x $170 per share)

6C.Common mistakes while trading:

  • Before one starts trading, deep research needs to be conducted on the sector and market in which the trade is being taken. One should be aware and updated with financial and economic news as it could significantly impact their trade.

  • Having a proper trading strategy is very essential, many traders tend to stop following their strategy after a few losses. There should be consistency in a trading plan to achieve profits.

  • A proper risk to reward ratio is very essential to avoid losses as one loss making trade can make one lose profits from multiple trades. Before entering a trade, the stop loss and target should be decided.

  • One should avoid overtrading during the trader either trying to cover up losses or make more profits from multiple trades. This could end up being stressful and can lead to wrong decisions.

  • Avoid taking tips from unknown people as it involves huge risk and might end up in major losses. One should invest with proper knowledge of the products and take advice only from a licensed advisor.


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