Wall Street Cheat Sheet: Trading Psychology

Psychologists studying the challenges faced by traders have identified a tight-knit relationship between the changing market cycles and traders' moods. They argue that these two factors are intertwined, emphasizing that the market isn't just a theoretical concept; it is deeply rooted in the behavioral tendencies of its participants. 

In other words, there's a clear correlation between price fluctuations and the psychological dispositions of traders.

Seasoned Wall Street traders have crafted a cheat sheet for newcomers. It displays a chart that juxtaposes the progression of a representative asset with the evolving emotions of a trader during price fluctuations.

To prevent financial missteps in the market, it's essential to grasp these emotions and not allow them to dominate decision-making processes.

Trading Psychology. Source: wallstcheatsheet.com

1. Disbelief. After a bearish trend, many novice traders hesitate to jump back into trading. They often choose caution, re-entering the market only once a clear upward trend starts forming. During this phase, seasoned traders usually seize the opportunity to buy assets. As a result, beginners frequently miss optimal entry points, later ruing their caution.

2. Hope. This stage can be likened to overconfidence. During brief periods when the asset's price climbs, novices might lower their defenses, investing more than they should, while neglecting the possibility of price retractions or corrections. To sidestep such oversights, it's beneficial to familiarize oneself with the Elliott Wave Theory.

3. Optimism & Belief. Greed commonly influences beginners at this juncture, leading them to overreach. They might, for example, start to utilize more significant leverage in hopes of amplifying potential profits. The advice from market pros: “If you're not adept at reading market indicators, it's wise to limit leverage to 1:5.”

4. Total Euphoria. This is the most treacherous stage for a novice trader. They often feel they've cracked the market's code, making them feel invincible. In their overconfidence, they may forget the unpredictability of the market and neglect essential safety measures like setting a stop-loss. A wise guideline during these times: “If you've earned more than you projected, close your position and step back.” Earning $100 is far preferable to losing $500.

5. Complacency. When the market trend starts to reverse, those traders who were riding high on euphoria just a day earlier typically console themselves by thinking it's merely a temporary correction and believe the price will bounce back shortly. They might resist taking action, holding onto their positions longer than is prudent.

6. Anxiety & Panic. These emotions come into play when the market's movement sharply diverges from the trader's expectations. During this turbulent phase, they usually make the most mistakes. They might sell assets at a lower value than they bought or make rash investments, trying to recover their losses.

7. Depression. This is when disappointment sets in, either with the chosen asset or the entire market. Burned by their experiences, many traders exit the market, promising themselves they won't venture back.

For those who remain resilient, the emotional roller coaster starts its cycle again, albeit with less intensity each time. With every round, the fervor of these emotions lessens. By understanding the psychological highs and lows experienced by every market participant, you can guard against potential setbacks. Recognizing how emotions can hinder your market awareness may help you make more informed decisions.

Successful investors consistently detach themselves from emotional turbulence and make their moves precisely when the majority are panicking.