Trading psychology is all about emotional and mental states that affect traders’ decision-making processes. Emotions, attitudes, and biases that affect a trader’s behavior and performance fall within this domain. These psychological factors can significantly impact how traders handle risk, deal with losses, and operate during the highs and lows of market cycles.
In this lesson, we discuss the key emotions that influence trading activity, the pitfalls they cause, and how traders can learn to avoid emotional trading. You can find a video summary at the end as well.
Contents
Emotional Triggers in Trading
Greed and fear
Greed and fear are two powerful emotions that often surface during trading. They can seriously impact risk-taking by distorting an emotional trader’s perception of the true probability of events.
Let’s suppose a stock would yield stellar returns if events X, Y, and Z all happened simultaneously. The chances of that happening might be very slim. But, a greedy trader might exaggerate those chances and heavily invest in that stock, rather than choosing other solid stocks that yield steady, good returns.
The reverse is true as well: A fearful trader may avoid strong stocks altogether if he or she overestimates the likelihood of an unlikely event that could send those stocks plummeting.
Figure 1: Fear and greed index
Overall, greed and fear can harm traders by causing them to exaggerate the probabilities of rare events. In fact, CNN has a popular “Fear & Greed Index” (see Figure 1), which captures these two emotions at the market level.
Traders and investors must be aware of the dangers of these emotions driving their trading behavior. Professional traders and investors recognize this fact (see Warren Buffett’s quote below).
“Be fearful when others are greedy, and greedy when others are fearful.”
— Warren Buffett, CEO of Berkshire Hathaway
Pride and regret
Pride and regret, just like greed and fear, can significantly influence our trading behavior.
Take pride, for example. When a trading strategy works out well, we feel proud of our success. This pride might lead us to share our achievements with others, or even “show off” in some cases. But here’s the catch: these feelings can push us toward suboptimal decisions. Imagine closing a profitable position too early, just so we can rush off to celebrate and share the win.
On the flip side, there’s regret—an emotion that often arises when trades go south and losses pile up. Regret is especially powerful, often overshadowing pride. To avoid experiencing regret, we might make impulsive decisions, leading to what’s known as regret avoidance. This tendency can steer us toward poor trading choices, which we’ll delve into further in the “Common Psychological Pitfalls in Trading” section.
14 emotional states of a trader
Figure 2
For beginners, trading can be an intense and nerve-wracking experience. Throughout a market cycle, traders often find themselves riding a rollercoaster of emotions, ranging from euphoria at market highs to despondency during downturns. In fact, emotional traders can experience up to 14 distinct emotions in just one market cycle, as shown in Figure 2.
And, here’s the narrative on how these 14 emotional states manifest themselves:
At the onset of a bull market, emotional traders become engulfed in a wave of unwavering optimism. This would induce them to invest in the stock market. With each upward tick, excitement mounts, propelling them to expand their stock portfolios further, ultimately driving prices even higher. They experience the thrill of witnessing the market index surge and their portfolio values flourish day by day. As the market scales unprecedented heights, they find themselves swept away by a state of euphoria.
However, as the market’s upward momentum abruptly halts, a sense of unease permeates the air. Has the party reached its climax? Is this the pinnacle? Anxiety creeps in, prompting these questions. Denial sets in as a defense mechanism: Maybe the forecasts aren’t as rosy, but surely nothing of substance has shifted! Those cautioning about a downturn are merely overly pessimistic economists! Yet, subsequent weeks bring a deluge of unfavorable news. Fear encircles traders as they witness their hard-earned profits dwindle. Desperation lingers as they anxiously await signs of a revival. Unfortunately, most of their prior gains have dissipated, leaving them disheartened.
As markets continue their downward spiral, panic ensues, marking the emotionally grueling phase. Traders find themselves engulfed in a sense of helplessness, a profound loss of control. Capitulation becomes inevitable, as they reluctantly accept defeat, willing to sell their stocks at any price to stem further losses. Under a cloud of despondency, a fraction of traders choose to exit the market, bidding farewell indefinitely.
Having weathered the storm, traders find themselves in a state of depression, plagued by regret and the agonizing sting of losses. Yet, as time passes, flickers of optimism gradually illuminate the horizon. Traders cautiously entertain renewed hope. A sense of relief is felt as market conditions begin to improve, signaling the advent of a new cycle, brimming with possibilities.
Common Psychological Pitfalls in Trading
Selling winners, holding on to losers
One of the most common trading behaviors that can negatively impact performance is the disposition effect. This refers to investors’ tendency to hold on to “losing” stocks while selling “winning” stocks too quickly—where “losing” and “winning” are defined relative to the purchase price. In a seminal research paper, Shefrin and Statman (1985) (full reference at the end) argue that pride and regret can be instrumental in generating the disposition effect.
Selling a stock at a gain provides traders with a sense of pride. It’s an opportunity to celebrate their success and perhaps even boast about their smart investment decision to colleagues or friends. This emotional reward often pushes traders to sell their winning positions prematurely instead of letting them grow further.
On the flip side, selling a stock at a loss triggers feelings of regret and discomfort. The trader may feel embarrassed about their decision to buy the stock and struggle with admitting losses to others. To avoid this pain, they often hold on to losing stocks in the hope of a recovery—a recovery that might never come.
“Cut your losses and let your winners run.”
— Investment adage.
Revenge trading
Emotions can also give rise to revenge trading. This occurs when traders, driven by frustration over previous losses, initiate impulsive trades that deviate from their strategy in an attempt to quickly recover what they’ve lost. Unfortunately, these hastily made decisions often result in even greater losses, as they lack careful planning and analysis.
Revenge trading becomes particularly dangerous when a trader adopts a gambling mindset, desperately chasing earlier losses. This is a textbook example of emotional trading, driven by the desire to avoid the regret of accepting losses. Ironically, such impulsive reactions tend to worsen the situation, as the trader loses focus and strays further from their strategy.
As the following quote suggests, revenge trading is a cycle best avoided.
“Revenge trading occurs when traders try to make back losses immediately after losing trades. Instead of taking the loss and reassessing the market, they double down with a desire to ‘get even’—often leading to larger, more devastating losses.”
A trader experiences analysis paralysis when they become unable to execute trades due to overthinking all the “what if” scenarios. While thorough research is essential for developing a sound trading strategy, overthinking can cause traders to miss valuable opportunities.
At the heart of analysis paralysis lies fear and similar emotions. Trading inherently involves risk, making it a challenging profession for those who struggle with uncertainty. To succeed, traders must have a robust risk management system in place and carefully evaluate their decisions. However, once the necessary groundwork is done, hesitation driven by fear must be overcome.
Controlling fear is crucial to avoid missing out on good trading opportunities. Trading requires the courage to act when the time is right, even in the face of uncertainty.
“Analysis paralysis is the tendency to overanalyze and overthink, leading to inaction. In trading, this can mean missing out on profitable opportunities because traders are too focused on trying to perfect their analysis rather than executing their strategy.”
So far, we have discussed how trading psychology affects trading behavior. In the final part of this lesson, we focus on tips that traders (especially inexperienced ones) can employ to avoid emotional trading.
Get to know your risk appetite
Most of us have a natural dislike for risk and expect rewards for taking it on. However, the level of risk aversion varies from trader to trader—some are more willing to embrace risk than others.
As a trader, it’s crucial to stay within your personal risk comfort zone. Doing so helps you avoid being overwhelmed by your emotions during periods of market volatility.
The takeaway? Be clear about your risk appetite. Even investment companies prioritize assessing their clients’ risk tolerance before recommending products. To help you gauge your own, we’ve included links to example questionnaires below.
Once a trader understands his risk appetite, he can build a suitable risk management system to support his trading strategy.
Practice with a demo trading account
Another effective way to avoid emotional trading is by practicing with a demo account before risking real money. This allows you to gain valuable experience in a risk-free environment, helping you build confidence without incurring financial losses. For beginners, it’s especially important to grasp the mechanics of trading—such as placing trade orders, selecting the right order types, and understanding the risks associated with different securities (e.g., large caps vs. small caps or stocks vs. bonds).
Fortunately, many digital platforms offer trading simulators and demo accounts to help you practice. For your convenience, we’ve included a list of some options below.
Success in trading rarely comes from random decision-making. One of the hallmarks of successful traders is their ability to create well-thought-out trading plans, review them regularly, and make adjustments as needed. A solid plan simplifies the trading process, establishes a routine, and keeps the trader focused.
Importantly, a trading plan also acts as a safeguard against emotional decision-making, especially during volatile market periods. By committing to the plan, traders are less likely to let emotions override rational thinking—it becomes a tool for self-discipline.
An effective trading plan should, among other things, align with the trader’s risk tolerance. This helps determine how to allocate funds across various asset classes or securities. Additionally, it should outline clear trading strategies, specifying when to take profits and when to cut losses, ensuring all trading decisions are grounded in logic rather than impulse.
Keep a trading journal
One of the most valuable learning tools for any trader is the objective evaluation of past performance. Instead of focusing on boasting about past profits—some of which may simply be due to luck—assess whether a particular strategy has consistently led to success. Similarly, rather than dwelling on regret over losses, identify patterns in your reasoning that might have led you to invest in underperforming stocks. This objective approach helps you move past emotions like pride and regret, enabling you to focus on the strategies and actions that truly work.
In this regard, maintaining a trading journal can be incredibly beneficial. If daily entries feel overwhelming, aim for at least weekly summaries. Use your journal as a tool for thoughtful reflection on your trading activity. Periodically revisiting older entries can provide valuable insights, reminding you of what worked, what didn’t, and how you can improve.
Video summary
You can watch our lesson on trading psychology in the video below.
