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Trading psychology

Recently, when I had gone to pick up my son from his university, I got an opportunity to listen to audio version of "Trading for a living" written by Alexander Elder while driving. I have read this book a few years ago. It was a great reinforcement experience of the principles and patterns governing the market.


Before jumping into the principles of trading psychology, little bit about the author. Alexander Elder is originally from Russia and pursued medicine at the age of 16. While working on a ship as a doctor in Africa, he jumped ship and received political asylum in United States. He worked as a psychiatrist and taught at Columbia university. His experience as a psychiatrist provided him a deep insight into psychology of trading.


Psychology is the study of human behavior. In the next few sections, we will emphasize on how human behavior influences the market dynamics.


Photo by cottonbro from Pexels


Are trading markets designed to be profitable

Markets are designed to be a zero sum game and operates in such a way that one can either break even or even lose money. It can be compared to a Roulette table in casino. If you are a buyer, there has got to be a seller in the market. If you are making money on the trade, seller should be losing money. So, there is a transfer of money from one trading party to the other. But, overall it is a zero sum game. It can even be negative if you include the slippage and commissions.


Who are the traders of the market

Legend has it that Wall Street in New York City was named after a wall that was built to keep the cattle straying away from Manhattan. Primarily, in the wall street, 4 kinds of animals represent different kind of traders - bulls, bears, hog and sheep.


Bulls represents a trader who make money in the rising market. Bulls love to buy low and sell high in the rising market.


Bears represents a trader who makes money in the falling market. Bears love to sell high and buy back low in the falling markets.


Hogs represents a trader who loses plot of their original strategy for the trade and becomes greedy. They refuse to lock in a profit on either bullish or bearish trade even though the trend has reversed


Sheep represents a trader who does not have any strategy and trades either based on gut feelings or based on news/tips. They are usually passive and have no clue how to protect their capital when the market becomes volatile.


It is important to have a disciplined trading strategy if you are risking the hard earned dollars in your stock market. Without a distinct buy and sell strategy, one can become either a hog or sheep.


There is a popular saying in wall street that summarizes what we mentioned above

" Bulls make money, bears make money, hogs get slaughtered and sheep gets butchered".


What is Price

Price bars that we see on the chart are formed when a transaction happens between bulls and bears. As mentioned in the previous section, bulls always want to buy low and bears always want to sell high and there is a tug of war happening between the two. So, how do they come to consensus. - due to the entry of hesitant traders who are fearful and do not have a well defined trading strategy. As the hesitant traders delay the action, bears become more skeptical and fear that they might have to sell at a lower price whereas bulls are more eager to buy rather than paying higher price. When a bull buys from a bear, a price event happens and is shown in the chart. Multiple transactions happen in a single day for a particular stock symbol.


Support and Resistance

Support and resistance are the price memories that traders have during their trading lifetimes. The traders may associate their price memories to the events/news that triggered the rebounds/fallouts/ reversals. Support is the price in a falling market when the rebound/reversal happens. If it had been a strong memory of the event remembered by thousands of traders, then even reversal happens. Resistance is the price in a rising market where the breakdown happens. If this resistance is remembered by lot of traders, then even reversal can happen. Some traders who have these memories may no longer be trading and the support and resistances created by their memories ( if not enough active traders) may fade away.


Technical Analysis

Technical Analysis is the study of price action along with support and resistances in a graphical way. One should be able to see the effect on the price as news comes in for the stock symbol. Visit our beginner page to learn more about technical analysis


Long term Mentality

In reality, only one percent of the traders are able to trade for a living. Lot of traders who enter the market believe trading is a quick rich scheme and start investing their hard earned money based on some random tips/news. They do not develop a well defined trading strategy and do not have a clue why they are doing what they are doing. Alexander recommends traders to have a long term mentality and spend time educating themselves how to pick winning trades, cut the losses and ultimately trade for a living.


Money management

Trading can be very stressful as it involves money. And it hurts badly when we lose money. Let us consider any sport. A team playing the sport have their share of wins and losses. Similarly, a trader will make and lose money on his trades. However, a good trader will have a well defined trading strategy in place that has atleast 51% probability of winning and also would have good position/money management process in place to cut his losses. Alexander recommends not to use more than 2% of portfolio in any single trade.


Summary

1. Market is a zero sum game. In addition, you might lose money with slippage and commissions ( now a days, there are no commissions). Slippages can happen if we trade market orders. It is recommended to trade limit orders

2. It is recommended not to trade based on tips and news. Have a long term mentality and develop your trading strategy based on price action along with support and resistances to trade with conviction.

3. Last but not the least, have a position management in place. Remember, if you have to make money, some one has to lose money. Theoretically, probability of you winning the trade is 50% ( if we have one buyer and one seller). Alexander Elder recommends no to trade more than 2% of your portfolio in any single trade.


Did you know that Breakout trading strategy is one strategy that be used for cryptos, stocks, options and other derivatives. Also, it gives you the best risk reward ratio (RRR) for the trades placed.


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