Speaking about psychological competences, important for a trader, I would first and foremost single out emotional intelligence. Under emotional intelligence, I understand the ability to distinguish and name your own and other people’s emotional states.
Why is emotional intelligence important for traders?
I suppose that many traders would like to “get rid of emotions” to avoid losses that emotions often cause. However, such ridding would make a person unable to make decisions. An ability to find your way in complicated social situations that are influenced by the “psychology of a crowd” (and a financial market is exactly such a situation) presumes not only the skill to single out patterns (graphic, statistical) from a mass of data but also to feel correctly the market sentiment. To a larger part, market sentiment is the information unavailable to algorithms (though there are attempts to create algorithms that would estimate market sentiment).
Putting things very simply, we might say that the price impulse, spurting from a range and supported by professional demand/supply, will provoke the stereotypical reaction of traders who will try to sell at “inflated” prices. As a result, the trend will further be moved mostly by the emotional reaction of short-term traders who would be closing their positions. A high level of emotional intelligence will let the trader detect such situations and react accordingly.
For sure, the main role of emotional intelligence is to detect your own emotions. If a person (trader) experiences some emotional state that they cannot recognize, this might distort the perception of the market and push out some important information. Simply speaking, the trader will start looking for reasons to make a trade (and find them). In contrast to a simple reactive action, when the trader moves the Stop Loss or “enjoys revenge” on the market, the process here is much more complicated and hard to detect. A trader with distorted perception of reality will be sure that their analysis has been objective, accounting for all necessary factors; alas, their attention will be focused very selectively.
That is why emotional intelligence is so important: it allows to realize your own emotional states in time and avoid distortions.
Main perceptual distortions in the market
Here are the most frequent perceptual distortions that traders may face:
- The urge to trade in an inactive market (the trader tries to enter when it would be wiser to just wait).
- The desire to go against a breakaway (escaping the range, the price will seem unlawfully “high” or “low”, so the trader will try to open a position, justifying it by “analysis”, drawing new lines and “channels”).
- Avoiding trades and risks in times of extremely low volatility (usually before a breakaway).
- Decreasing activity after a losing series.
- Increasing activity after a profitable series.
I intentionally skip such types of behavior as increasing the lot significantly to win back your losses or make a certain amount of profit. We speak just about mental distortions, not the lack of self-control. When emotions exceed the “pain threshold” and rule one’s behavior, another mechanism that we are going to touch upon comes to the scene.
Most “bad” trades appear when the trader squeezes their perception into a narrow framework and becomes blind to important events and details.
Trader’s daily checklist
To avoid such effects, I recommend the following exercise. Do it every day before you start trading (and also in the process of trading and afterwards).
Before you open the trading terminal, take a pen and a sheet of paper and write down:
- What is going on with you right now?
- What is your current mood and what has provoked it?
- What has happened today or happened yesterday? Can you name any events that made you feel nervous or unsatisfied?
First, it might seem difficult to define your current mood; normally, we do not feel serious anxiety or annoyance; these processes are usually unconscious and do not influence our daily behavior directly. However, they will inevitably show themselves in trading.
Do your best to be as sincere as possible while righting down such checklists.
Also, I would recommend using diversified vocabulary to express your feelings: the adjectives “bad”, “good”, or “normal” describe virtually nothing, hence, the effect of the exercise will be close to null.
Some people would first concentrate on bodily feelings: as a rule, corporal reactions reflect unconscious emotional states, and watching such reactions may lead you to their source.
When you succeed in the exercise, you will feel calmer; your desire to start trading as soon as possible will subside, and your view of the market picture will extend. The framework of perception, bound by your unconscious emotions, will widen, which means you will notice much more scenarios of behavior – both your own and the market. Such diversity will increase your chances for finding good trades and making a profit.
Instead of a summary
In the University of California, an interesting experiment was carried out: experienced (but not expert) traders and beginners worked in the market. First, experienced traders performed better, but then beginners completed a special program meant for the development of emotional intelligence, caught up with the experienced colleagues, and some of the beginners even became leaders. The measurements of brain activity demonstrated that logic hardly participated in the process.