#TradingPsychology Live

Table of Contents

Trading

 

Trading Skills

Trading Psychology: Definition, Examples, Importance in Investing

By 

Kerron Blandin

 

Updated March 01, 2025

Reviewed by 

Somer Anderson

Fact checked by 

Yarilet Perez

Part of the Series

Day Trading Introduction

What is Trading Psychology?

Trading psychology refers to the emotions and mental states that help dictate success or failure in trading securities. Trading psychology represents various aspects of an individual’s character and behaviors that influence their trading actions and can be as important as other attributes, such as knowledge, experience, and skill in determining trading success.

Discipline and risk-taking are two of the most critical aspects of trading psychology since a trader’s implementation of these aspects is critical to the success of their trading plan. Fear and greed are commonly associated with trading psychology, while things like hope and regret also play roles in trading behavior.

Key Takeaways

Trading psychology is the emotional component of an investor's decision-making process, which may help explain why some decisions appear more rational than others.

Trading psychology is characterized primarily by the influence of both greed and fear.

Greed drives decisions that might be too risky.

Fear drives decisions that might avoid risk and generate little return.

Behavioral finance has documented several psychological biases and errors involved when making trading or investment decisions.

Understanding Trading Psychology

Trading psychology can be associated with a few specific emotions and behaviors that are often catalysts for market trading. Conventional characterizations of emotionally driven behavior in markets ascribe most emotional trading to either greed or fear.

Greed can be thought of as an excessive desire for wealth, so extreme that it sometimes clouds rationality and judgment. Greed can lead traders toward a variety of suboptimal behaviors. This may include making high-risk trades, buying shares of an untested company or technology just because it is going up in price rapidly, or buying shares without researching the underlying investment.

Overconfidence: Overconfidence is the tendency to overestimate one's own abilities, skills and knowledge. Many investors believe themselves to be more skilled in investing than other market participants. It is, however, statistically impossible for most investors to be above average. Overconfident investors have the tendency to trade excessively, resulting in higher transaction costs and poor performance. Studies also show that overconfident investors overestimate their own predictive abilities, and precision of data given, resulting in emotionally charged behavior and excessive risk taking.

Herd behavior: Herd behavior states that people tend to mimic the financial behaviors of the majority of the herd. The natural human desire to feel like a part of the crowd, at times influences investors to follow the investment actions of others. When a crowd is generally going in one direction, an individual may feel uncomfortable or wrong for going in the opposite direction. As such, investors may follow the crowd by purchasing assets perceived to be purchased by the crowd, neglecting to do their own research and assuming that others have done research. Herding is notorious in the stock market as the cause behind dramatic rallies and sell-offs. The dotcom bubble was a recent example of this, wherein investors following the crowd, purchased securities in many internet-based businesses in anticipation of future profits, which never materialized, resulting in a sharp sell-off.

Emotional gap: The emotional gap refers to decision-making based on extreme emotions or emotional strains, such as anxiety, anger, fear, or excitement. Emotions are often a key reason why people make irrational choices. As mentioned before, fear and greed are notable drivers of human behavior, which can result in overreactions, giving rise to unfounded optimism, irrational exuberance and asset bubbles, or conversely, market panic and major sell-offs.

have anchored their estimate of fair value to their original purchase price. Such investors may hold the security in hope of its return to the purchase price, without regard to its future prospects or outlook.

Self-attribution: Self-attribution refers to a tendency to regard successes as resulting from their own personal abilities, while regarding failures to be the cause of external factors. Self- knowledge higher than others, even when it objectively falls short. As such, an investor may attribute successful investment performance to their own superior decision making skills but attribute poor performance, not to poor decision making, but to bad luck.

Loss aversion is a common psychological error that occurs when investors place more weight on the concern for losses than the pleasure from market gains. Losses prompt more emotional reactions within investors than the impact of an equivalent amount of gains. In other words, they're far more likely to prioritize avoiding losses over making

Traders generally face two categories of behavioral biases: cognitive biases and emotional biases. Cognitive biases are patterns of errors or blind spots in thinking that are common to human beings, which result from subconscious mental processes. These may include overconfidence bias, mental accounting and anchoring bias, among other examples.

Emotional biases are deviations from rationality arising from feelings, moods, perceptions, or beliefs. These include herding behavior, loss aversion bias and the emotional impacts of fear Pitfalls of Traders Neglecting Trading Psychology?

Investors and traders are prone to behavioral biases and can encounter multiple pitfalls. These may include selling winning investments quickly while holding on to losing investments for too long in hopes of recovery to the purchase price. Traders may follow the crowd in chasing recent top-performing assets, ignoring the need for due diligence and disregarding data on future prospects of the investment. They may act impulsively on information received, based on their perceived superior investing abilities. Another pitfall may be trading excessively while underestimating investment risk and failing to adequately diversify investments. Emotional responses to feelings of fear or greed may lead to impulsive decision-making during periods of market volatility. Understanding the concepts of trading psychology can assist in making more informed and rational decisions.

How Can Traders Overcome Biases to Avoid Pitfalls?

In order to overcome biases, traders can employ many strategies. Improving education of behavioral finance principles can enhance self-awareness and improve decision making. Developing and sticking to a trading plan with trading rules and risk management practices, can provide a structured approach to investing, minimizing room for emotional decision making. Performing their own objective fundamental or technical analysis research on investment opportunities and seeking a range of data to support the analysis, including contrarian perspectives, can assist in avoiding herd-following behavior and challenge existing beliefs.