Psychology of Money Management

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Introduction 

The Psychology of trading is probably the most important aspect to grasp for any trader or investor. Your emotions need to be managed and traders need to understand other trader’s emotions. Trading isn’t all about how to pick entry points after in depth technical analysis and subsequently select exit points. It also about being able to stick to your trading strategy and being able to think on your feet to exit if you have to. Understanding the psychology of money management will help you reduce losses and give you conviction to follow a good trading strategy. This is why psychology is so important.

Managing Losing Trading Positions with your System 

One thing that’s really going to keep a trader on nerve is managing losses. All traders need strength of mind to manage losses, which is more important than managing your wins. There is particular importance in managing your fear of being wrong, as you will be wrong A LOT. 

A successful trading system doesn’t always have to be right all the time. You must be able to take losses within your trading system. A successful trading system may have 1 winner to 5 losers and an unsuccessful system may have 5 winners to 1 looser. It all depends on the levels of profit and loss within the system. 9 time out of 10 people will pick system 2 to trade, as all they can see are winners. This system may have a small profit on winning trades, but larger losers.  Even if these people have gone through system 2 and experienced the large lose, they can’t believe it won’t work in the future until it’s too late.

If we bring a 3rd system into play and it has 6 winners, system 1 may still be better as the profit on each winner of system 3 may be very small. Over a year system 1 may make 10 x the profit of system 3. As human beings we only see winner, winner, winner, winner against loser, loser, loser, loser. We need to be able to take losses to win. Most successful trading systems follow option 1.

The Dangers of Crowd Mentality

Following the crowd can lead to money management failure. We react differently when part of a crowd in all walks of life, whether it’s at a football match or on a demo. We change when in a crowd, becoming more compulsive, trusting, irrational and emotional. We tend to join in and need to search for a leader. In trading it’s exactly the same.

In trading we can see this crowd mentality over and over again. The Internet bubble in 2000 can be seen in this light and in fact history is littered with Bubbles (1929 crash, case in point). History repeats itself because people have a desire to be part of a group and we don’t like to miss out. As momentum in The Nasdaq increased more and more people wanted to be part of the crowd. This is fine if valuations and economic growth forecasts support this, but as Dow theory suggests in Tenet 2 once the trend hits phase three (The Excess Phase) rampant speculation occurs and maybe it’s time to take profits. So you need to make the decision when to trade with the crowd and when to get out. Trading with the crowd can be very beneficial to catch strong trend etc… but stay logical and follow your trading strategy without emotion. 

The Psychology of Taking Profits

Traders have problems deciding to take profits. What I mean by that is they battle with themselves to take them, or let them run at the risk of loosing out further down the line. What do you take? A sure 10K or a 95% chance of 20K & 5% chance of ZERO? 80% of people would take the 10K, but this goes against the 1st rule of trading to let your profits run.  This is an extreme example, because if we use stop/loss positions then ZERO is unlikely. 

There are trading strategies that allow traders to let their profits run. Trailing stops is one such strategy and we’ve shown how this can be achieved in our module on parabolic SAR and in “Using Trailing Stops for profit taking” under money management. You can also set trailing stops manually, by moving your stop/loss every so often giving your trade room to develop and lock in profits if the move goes against you.  We look at stop/loss positions in the money management section.

To Sum Up

Think independently. Money is made by developing your own ideas and following a method that is designed to fit you and your personality. Stock Market traders and investors make money by finding themselves, achieving their potential, and getting in tune with the stock market.

While conventional theory describes situations in which all the players in the market behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can't be predicted by simply looking at the fundamentals.

Technical analysts use trends, patterns and other indicators to assess the market's current psychological state in order to predict whether the market is heading in an upward or downward direction. Other technical indicators help with money management - USE THEM as part of your trading strategy.

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Introduction 

The Psychology of trading is probably the most important aspect to grasp for any trader or investor. Your emotions need to be managed and traders need to understand other trader’s emotions. Trading isn’t all about how to pick entry points after in depth technical analysis and subsequently select exit points. It also about being able to stick to your trading strategy and being able to think on your feet to exit if you have to. Understanding the psychology of money management will help you reduce losses and give you conviction to follow a good trading strategy. This is why psychology is so important.

Managing Losing Trading Positions with your System 

One thing that’s really going to keep a trader on nerve is managing losses. All traders need strength of mind to manage losses, which is more important than managing your wins. There is particular importance in managing your fear of being wrong, as you will be wrong A LOT. 

A successful trading system doesn’t always have to be right all the time. You must be able to take losses within your trading system. A successful trading system may have 1 winner to 5 losers and an unsuccessful system may have 5 winners to 1 looser. It all depends on the levels of profit and loss within the system. 9 time out of 10 people will pick system 2 to trade, as all they can see are winners. This system may have a small profit on winning trades, but larger losers.  Even if these people have gone through system 2 and experienced the large lose, they can’t believe it won’t work in the future until it’s too late.

If we bring a 3rd system into play and it has 6 winners, system 1 may still be better as the profit on each winner of system 3 may be very small. Over a year system 1 may make 10 x the profit of system 3. As human beings we only see winner, winner, winner, winner against loser, loser, loser, loser. We need to be able to take losses to win. Most successful trading systems follow option 1.

The Dangers of Crowd Mentality

Following the crowd can lead to money management failure. We react differently when part of a crowd in all walks of life, whether it’s at a football match or on a demo. We change when in a crowd, becoming more compulsive, trusting, irrational and emotional. We tend to join in and need to search for a leader. In trading it’s exactly the same.

In trading we can see this crowd mentality over and over again. The Internet bubble in 2000 can be seen in this light and in fact history is littered with Bubbles (1929 crash, case in point). History repeats itself because people have a desire to be part of a group and we don’t like to miss out. As momentum in The Nasdaq increased more and more people wanted to be part of the crowd. This is fine if valuations and economic growth forecasts support this, but as Dow theory suggests in Tenet 2 once the trend hits phase three (The Excess Phase) rampant speculation occurs and maybe it’s time to take profits. So you need to make the decision when to trade with the crowd and when to get out. Trading with the crowd can be very beneficial to catch strong trend etc… but stay logical and follow your trading strategy without emotion. 

The Psychology of Taking Profits

Traders have problems deciding to take profits. What I mean by that is they battle with themselves to take them, or let them run at the risk of loosing out further down the line. What do you take? A sure 10K or a 95% chance of 20K & 5% chance of ZERO? 80% of people would take the 10K, but this goes against the 1st rule of trading to let your profits run.  This is an extreme example, because if we use stop/loss positions then ZERO is unlikely. 

There are trading strategies that allow traders to let their profits run. Trailing stops is one such strategy and we’ve shown how this can be achieved in our module on parabolic SAR and in “Using Trailing Stops for profit taking” under money management. You can also set trailing stops manually, by moving your stop/loss every so often giving your trade room to develop and lock in profits if the move goes against you.  We look at stop/loss positions in the money management section.

To Sum Up

Think independently. Money is made by developing your own ideas and following a method that is designed to fit you and your personality. Stock Market traders and investors make money by finding themselves, achieving their potential, and getting in tune with the stock market.

While conventional theory describes situations in which all the players in the market behave rationally, not accounting for the emotional aspect of the market can sometimes lead to unexpected outcomes that can't be predicted by simply looking at the fundamentals.

Technical analysts use trends, patterns and other indicators to assess the market's current psychological state in order to predict whether the market is heading in an upward or downward direction. Other technical indicators help with money management - USE THEM as part of your trading strategy.

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