Stock market psychology refers to the ability to identity and manage emotions and behaviors that may arise while trading. While the stock market is a forward-looking indicator for expectations around corporate earnings performance, it is often also swayed by factors which influence trading psychology on an individual and a collective level.
Three factors to consider are:
- Investor mood
- Market sentiment
- Emotions such as fear or greed
The aim of this article is to explain the importance of trading psychology in the stock market and to provide additional knowledge and tips on how this can be managed. For a brief introduction to the stock market, see our guide to stock trading for beginners.
The importance of psychology when trading the stock market
The importance of psychology in the stock market is often underestimated but it can be extremely beneficial for a trader to be able to identify and manage these psychological factors. On a personal level, irrational investment decisions are often driven by emotions such as fear, greed and the fear of missing out (FOMO in trading). However, crowd psychology is also a contributor of large market swings which could trigger emotions, leading to fear-based trading.
An example of this can be seen during a global pandemic. As panic increases, stock market volatility will often follow. An increase in volatility is usually followed by one of two emotions, fear or FOMO. Pessimism seems to have a greater impact on volatility than optimism does. An increase in fear will often lead to ‘panic selling’ where traders rush to exit trades in an attempt to avoid greater losses.
A good measure of volatility can be seen in market sentiment which is a tool used to measure how investors perceive a market at a given time. When traders perceive the market as bearish, there will be more sellers than buyers in the market which means that crowd psychology is negative.
The clearest way to determine crowd psychology for stocks is through stock indices. A stock index tracks a collection of stocks within a specific country or market. Major stock indices are used to compare returns on different assets and to track the overall economy through the overall performance of the index.
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What are the main drivers of trading sentiment?
Once a trader understands the psychology on a personal and collective level, it is important for the trader to manage emotions accordingly. Although some emotions should be embraced, negative effects of trading psychology generally have a greater impact on investment decisions than that of positive psychology.
Emotions such as fear and greed can have negative effects by causing traders to act impulsively. An example of fear-based trading can be seen when a trader closes a position prematurely. Fear may also turn to greed when traders holds onto losing positions for a long period of time, fearful of realizing a loss.
To benefit from stock market psychology, a trader should embrace the positive psychological factors while attempting to manage the negative aspects.
5 ways to manage psychology when trading stocks
1. Develop a trading plan
A trading plan is used by traders as a guide throughout the trading process. It is a set of rules that outlines the conditions that should be met before a trade is triggered, which markets should be traded and when to exit the trades. The purpose of a trading plan is to ensure that the trader remains accountable and sticks to the plan.
2. Make a checklist
Having a trading plan is one thing but sticking to it is completely different story when trades go against you. Having a brief checklist on hand ensures that the trader is applying the rules outlined in the trading plan throughout the trading process.
3. Keep a journal
As a trader, it is important to assess your progress and to identify areas of improvements. A journal is a great way to do this as it allows a trader to keep track of all trades and assess what worked and what didn’t. At times, a journal will identify gaps in a trading plan or strategy that may need to be addressed.
4. Set realistic expectations and build confidence
Building confidence can be difficult, especially in the beginning stages where a strategy is still being tested. Confidence is vital as a confident trader is more likely to take calculated risks, and to accept the outcome of those risks. This is because a confident trader is usually one who is aware of their own trading psychology and has put processes in place to manage these factors. One possible way to build confidence in trading while learning about trading psychology would be to trade on a demo account. The goal is to set realistic expectations and treat the demo account as if it were real money.
5. Practice risk management
Risk management is something a trader cannot afford to ignore. Determining risk/reward ratios, trading with stop losses and trading reasonable trade sizes are all essential elements of a good risk management strategy.
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Psychology and the Stock Market FAQs
Does trading psychology only apply to the stock market?
Trading psychology applies to all financial markets and instruments. Regardless of the instrument traded, emotions will always play a part which is why it is so important to have measures in place that keep you focused on your goals, regardless of emotions.