A traders emotions, ego, and thinking can become very distorted when real money is at risk in the markets. Hormones like serotonin, dopamine, and adrenaline can cause impulses and emotions to drown out thinking and decision making skills.
Emotional intelligence is one of the most important skills a trader can possess, this is the ability to think at a level higher than your emotional reactions to circumstances. A trader must have the abilities of self awareness, self control, and be able to express emotions in a positive way. It helps with performance for a trader’s self talk to remain positive and constructive, dealing with facts and reality and not become negative or catastrophizing circumstances.
The price action and volatility of the markets can be difficult enough without adding personal issues and weaknesses into a trading system. You will never be able to control or predict the market, the best you can do is control your own actions and predict what you will do in response to price action.
Here are the primary things that cause the psychology of trader misjudgment.
Traders are incentivized to make money, that is why they are trading. They start trading by seeing everything through the lens of making money. They take profits early to lock in a small winning trade to make money, they let a losing trade run hoping it will get back to at least even because they don’t want to lose money, they think more trades will make them more money so they over trade. If a trader really wants to make money they need to be focused on the big picture of a complete trading system not the small picture of one trade. They have to see how it all fits together to make money. A big part of this process is letting winners run and cutting losers short.
Psychological denial will cause a trader to think they are special and have a natural ability as a trader. Denial can cause a trader to not see a trend because they don’t believe that it should be happening. Denial can cause a trader to refuse to exit a losing trade as they can’t believe it will not bounce back. every trader should be accepting the current market reality and never deny what is actually happening.
A trader can have an ownership bias when they are long or short a position. A trader that identifies as a bull or bear can start reading information from a biased perspective only seeing what supports their current positions. Signals are great equalizers in current position bias blindness by making a trader follow the plan they had to get out before they got in.
Misjudging the past correlation of professional success as a reliable basis for trading success. High performing professionals in other fields like doctors, lawyers, and executives can think their skills will carry over into trading the financial markets. They can believe their intelligence is an edge but many times the principles of successful trading are very different than in medicine, law, and the business world. Opinions, predictions, and ego are not strengths in trading. Admitting you are wrong, going with the flow, and staying flexible are skills unique to trading most of the time. Creating a system with an edge is what leads to trading success not success in past careers.
Misjudgement based on ego. Once a trader publicly announces a trade, opinion, or prediction they can become entrenched in defending this position and abandon logic, reason, and reality. Even becoming more convinced they are right the farther the position moves against them because they think a reversal has a higher probability the more it moves in the wrong direction. This is ego blindness and caused by the ego taking over the thinking process as it refuses to be proven wrong.
It can be bad judgement to be bullish or bearish simply because the majority of people are. Many times the top of a chart happens when most people are very bullish and the bottom usually happens when the majority of people are bearish. Most of the money is made in the trend of a chart between the top and bottom, getting in too late can be very expensive.
Here are some of the top cognitive errors that cause bad judgement. The primary reason why mechanical trading systems and rule based trading have an edge is by eliminating most of these errors of traders bad judgement when emotions and ego interfere with following a profitable trading process.