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#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.

#StopLossStrategies

Table of Contents

Trading Skills

 

Trading Orders

The Stop-Loss Order—Make Sure You Use It

By 

The Investopedia Team

 

Updated April 10, 2024

Reviewed by 

Somer Anderson

Fact checked by 

Yarilet Perez



 kate_sept2004/Getty Images

0 seconds of 2 minutes, 24 seconds

 

With so many things to consider when deciding whether or not to buy a stock, it's easy to omit some important considerations. The stop-loss order may be one of those factors.

When used appropriately, a stop-loss order can make a world of difference. And just about everybody can benefit from this tool.

Key Takeaways

Most investors can benefit from implementing a stop-loss order.

A stop-loss is designed to limit an investor's loss on a security position that makes an unfavorable move.

One key advantage of using a stop-loss order is you don't need to monitor your holdings daily.

A disadvantage is that a short-term price fluctuation could activate the stop and trigger an unnecessary sale.

What Is a Stop-Loss Order?

A stop-loss order is an order placed with a broker to buy or sell a specific stock once the stock reaches a certain price.1 A stop-loss is designed to limit an investor's loss on a security position. For example, setting a stop-loss order for 10% below the price at which you bought the stock will limit your loss to 10%. Suppose you just purchased Microsoft (MSFT) at $20 per share. Right after buying the stock, you enter a stop-loss order for $18. If the stock falls below $18, your shares will then be sold at the prevailing market price.

Stop-limit orders are similar to stop-loss orders. However, as their name states, there is a limit on the price at which they will execute. There are then two prices specified in a stop-limit order: the stop price, which will convert the order to a sell order, and the limit price. Instead of the order becoming a market order to sell, the sell order becomes a limit order that will only execute at the limit price (or better).

One alternative to using stop orders is to use option contracts to limit your downside losses during market swings.

Advantages of the Stop-Loss Order

The most important benefit of a stop-loss order is that it costs nothing to implement. Your regular commission is charged only once the stop-loss price has been reached and the stock must be sold. One way to think of a stop-loss order is as a free insurance policy.1

Additionally, when it comes to stop-loss orders, you don't have to monitor how a stock is performing daily. This convenience is especially handy when you are on vacation or in a situation that prevents you from watching your stocks for an extended period.

Stop-loss orders also help insulate your decision-making from emotional influences. People tend to "fall in love" with stocks. For example, they may maintain the false belief that if they give a stock another chance, it will come around. In actuality, this delay may only cause losses to mount.2

No matter what type of investor you are, you should be able to easily identify why you own a stock. A value investor's criteria will be different from the criteria of a growth investor, which will be different from the criteria of an active trader. No matter what the strategy is, the strategy will only work if you stick to it. So, if you are a hardcore buy-and-hold investor, your stop-loss orders are next to useless.

At the end of the day, if you are going to be a successful investor, you have to be confident in your strategy. This means carrying through with your plan. The advantage of stop-loss orders is that they can help you stay on track and prevent your judgment from getting clouded with emotion.

Finally, it's important to realize that stop-loss orders do not guarantee you'll make money in the stock market; you still have to make intelligent investment decisions. If you don't, you'll lose just as much money as you would without a stop-loss (only at a much slower rate.)

Stop-Loss Orders Are Also a Way to Lock In Profits

Stop-loss orders are traditionally thought of as a way to prevent losses. However, another use of this tool is to lock in profits. In this case, you can use a "trailing stop." The trailing stop can be designated in either points or percentages. The stop order then trails price as it moves up for sell orders, or down for buy orders.

Continuing with our Microsoft example from above, suppose you set a trailing stop order for 10% below the current price, and the stock skyrockets to $30 within a month. Your trailing-stop order would then lock in at $27 per share ($30 - (10% x $30) = $27). Because this is the worst price you would receive, even if the stock takes an unexpected dip, you won't be in the red. Of course, keep in mind the stop-loss order is still a market order—it simply stays dormant and is activated only when the trigger price is reached. So, the price your sale actually trades at may be slightly different than the specified trigger price.

Disadvantages of Stop-Loss Orders

The main disadvantage is that a short-term fluctuation in a stock's price could activate the stop price. The key is picking a stop-loss percentage that allows a stock to fluctuate day-to-day, while also preventing as much downside risk as possible. Setting a 5% stop-loss order on a stock that has a history of fluctuating 10% or more in a week may not be the best strategy. You'll most likely just lose money on the commission generated from the execution of your stop-loss order.

There are no hard-and-fast rules for the level at which stops should be placed; it totally depends on your individual investing style. An active trader might use a 5% level, while a long-term investor might choose 15% or more.

Another thing to keep in mind is that, once you reach your stop price, your stop order becomes a market order. So, the price at which you sell may be much different from the stop price. This fact is especially true in a fast-moving market where stock prices can change rapidly.3 Another restriction with the stop-loss order is that many brokers do not allow you to place a stop order on certain securities like OTC Bulletin Board stocks or penny stocks.

Stop-limit orders have further potential risks. These orders can guarantee a price limit, but the trade may not be executed. This can harm investors during a fast market if the stop order triggers, but the limit order does not get filled before the market price blasts through the limit price. If bad news comes out about a company and the limit price is only $1 or $2 below the stop-loss price, then the investor must hold onto the stock for an indeterminate period before the share price rises again. Both types of orders can be entered as either day or good-until-canceled (GTC) orders.

Why Use a Stop-Loss Order?

A stop-loss order is a risk-management tool that automatically sells a security once it reaches a certain price (either a percentage or a dollar amount below the current market price). It is designed to limit losses in case the security's price drops below that price level. Because of this it is useful for hedging downside risk and keeping losses more manageable.

One benefit of using a stop-loss is that it can help prevent emotion-driven decisions, such as holding onto a losing investment in the hopes that it will eventually recover. A stop-loss order can also be useful for investors who cannot constantly monitor their investments.

What Are the Risks of Using Stop-Loss Orders?

A risk of using a stop-loss order is that it may be triggered by a temporary price fluctuation, causing the investor to sell unnecessarily. For example, if a security's price drops suddenly and then quickly recovers. Here, you may end up selling at a loss and missing out on potential gains.

Can A Stop-Loss Trigger a Buy Order?

Yes, stop-losses can also be used for placing orders (known as a buy stop). It allows an investor to automatically buy a security once it reaches a certain price. This type of order can be useful for investors who want to enter a position at a specific price point.

How Should I Determine the Price Level for a Stop-Loss?

Determining the best price for a stop-loss order depends on a variety of factors, including your risk tolerance, the volatility of the security, and your investment goals. Investors often use technical analysis tools such as support and resistance levels to help identify a good price for a stop-loss order. Specific markets or securities can be studied to understand whether retracements are common. Securities that show retracements require a more active stop-loss and re-entry strategy.

The Bottom Line

A stop-loss order is a simple tool that can offer significant advantages when used effectively. Whether to prevent excessive losses or to lock in profits, nearly all investing styles can benefit from this tool. Think of a stop-loss as an insurance policy: You hope you never have to use it, but it's good to know you have the protection should you need it.