Understanding how basic emotions could influence your trading decisions

• How basic emotions can affect rational thinking?
• What emotions you might feel while trading and how they can influence your trading behaviour?
• What you can do to keep your emotions under control.

The human brain is a very complex organ.

It controls everything we do, from a blink of an eye, and a slight movement of our limbs to how we digest and use nutrients from the food that we eat. From that angle at least, this is not so different from what the brain of an animal does.

Emotions in non-human animals are still quite a controversial topic, but it has been studied in a large number of species, large and small, including primates, rodents, elephants, horses, birds, dogs, cats, honeybees, and crayfish.

Our brain plays a huge role in how our experiences are turned into emotions from basic mechanisms driven by the production of hormones or through using your memory as a filter for processing your past experiences.

For us, modern humans, these emotions however might act against us sometimes and push us to do irrational or unintended things.

Although we may think we make most of our decisions based on thorough analysis and critical thinking, many traders base some of their decisions on feelings. We all experience various emotions each day, and some of them might influence our decision-making process, including the decisions we make when trading the markets.

Traders who have greater control over their feelings and emotions are more likely to make more logical decisions, rather than follow their feelings.

One of the most common emotions a trader could face while trading financial markets is fear. The goal of trading is to place a trade expecting the price to move in the direction of your favour, unfortunately, this is not always the case. The fear starts to build up as soon as your positions start to lead to losses. This is when, despite a carefully planned trading strategy, many traders decide to take sudden actions.

Here are some examples of trading decisions based on fear:

• Deciding not to enter into a trade because of the potential of losing.
• A phenomenon called the ‘sunk-cost effect’: sticking to a losing trade because of the time and money invested in it.
• Not closing a losing trade because of the loss would be accounted for while there is a potential for it to recover in the future.
• Closing a trade too early because of the fear of losing the profit gained so far.

Trying to understand the origin of the fear and sticking to your trading strategy or plan is the easiest way to control this emotion.

Greed is one other common emotion accompanying traders﹣it seems logical at first: people start trading in the hope of earning money and securing their future. But how does one decide that enough is enough, especially if the market is moving in their favour? This is exactly the aspect of greed that causes traders to lose their trades.

Examples of greed acting against the trader:

• Having the position open for too long, despite it having already achieved the profit hoped for at the time of opening.
• Moving the Take Profit threshold as the market moves in your favour.
• Over-trading ﹣ using too much margin in the hope of fast gains or simply trading too much.

Setting an appropriate risk-reward ratio in your trading strategy could help to deal with greed-led decisions.

Hope in itself seems to be harmless and a very positive emotion. In trading, however, if the hope is not embedded and based on logic it may lead to severe losses. Hope often goes in pairs with fear or greed. This combo is even more dangerous, as it often crosses out a carefully prepared trading strategy and turns it into emotion-based betting.

How hope can manifest itself in trading leading to loss:

• Following a recommendation from others, not understanding the underlying situation in the hope that others are right.
• Hope and fear combined can lead to keeping a losing position open in the hope for it to recover the losses.
• Hope and greed often lead to not closing positions once they become profitable and the goal of the trade is already achieved.

Regret in trading is inevitable, especially when you create a very strict trading strategy for yourself and don’t go with the flow or hold off with opening a position. ‘What would have happened if I had placed that trade?’, ‘I have missed that big opportunity because I wasn’t certain I was willing to accept the risk!’. Those are just some examples of how regret is getting you.

• Becoming more risk-accepting when placing future trades based on the fact of missed opportunities in the past.
• Moving away from your tested trading strategy because it made you not follow an emerging opportunity before.
• Turning into a copy trader who follows the behaviours of others instead of doing your analysis for the trades you make.

How many times have you heard or thought: ‘If only I had invested in Apple stock’?

Opportunities come and go and it is extremely difficult to spot them. It is normal to feel this kind of anxiety or jealousy after some traders gain, but don’t let your emotions take over pushing you to enter the game yourself while the game has already been played.

It is also very tempting to consider entering the trade while there seems to be a ‘hype’ for something based on assumptions that it has worked before.

Overcoming the fear of missing out (FOMO) is hard, especially when markets become volatile, rumours and news spread (especially on social media) or you experienced a series of losses or maybe even you had a big winning strike and you are looking for another big win.

Jealousy towards other traders on the other hand does not automatically make you a worse trader, as long as you are making profits, your acceptable risk level might be just right. The higher the risk, the higher the gain might be, yet the same applies to potential losses.

Many people, especially successful ones, think that being smart automatically makes you a good trader. They expect to be as successful with trading, as with anything else. The thing is, that smart people make wrong decisions (as anyone else), yet they still often expect to be ‘right’ all the time. Traders with that attitude can often get irritated and as a result get confused about what the real goal of trading is: it is managing risk and return, not being right.

No matter how hard you try, you will suffer losses and lose money at times. It is important to understand that what matters the most is having a strategy that manages risk effectively and aims to preserve capital. That is the measure of a trader's success.

The risk for an ego-driven trader is to get demotivated as a result, as it might be difficult for them to deal with losing trades they placed.

Ego-driven trading behaviours:

• Placing a trade with the assumption that your strategy is bulletproof.
• Not having a strategy and following advice or hunches blindly.
• Investing too much and often zeroing their accounts easily.
• Way too high confidence level and not using any risk management order types.

The key to controlling your emotions is acknowledging them and taking a moment to look at your motives from a distance. You already learned about some of these emotions and how they manifest which is the foundation of not falling for your instincts when trading.

On top of understanding your emotions, other aspects would help you avoid acting under their influence:

Consider creating your trading strategy - define your risk appetite and timeframe for your trading based on how long you can deal with an emotion attached to a trade. Some asset classes carry more risk than others, select those that match your trading style and your risk/reward ratio. Decide what amount of technical and fundamental analysis you want to embed into your trading and avoid relying on just one signal. If you are a technical trader, it is a good practice not to rely on one timeframe and indicator only.

When you get distracted by market noise, you become prone to acting under emotions. Try to filter out some noise to get a clearer picture of the market you are in. Consider taking advantage of technical indicators, such as moving averages to eliminate the noise created by whipsaw price movements.

Take a step back and ask yourself, 'What is this emotion that I feel at the moment?' and ‘Is my current state affecting my judgement?' ’. Focus on your emotions. Finding out what you feel and naming your emotions is the first step to controlling them and applying logical thinking to help put your emotions aside. Thinking logically helps you come to rational decisions based on facts rather than feelings. Always question yourself if the decision is based on facts and data, rather than emotions.

Market moves might be emotionally driven – traders look for opportunities and seek out entry points as they perceive a new trend to be forming.

At the same time, geopolitical situations, politics, markets, and news sentiment can feed on the same emotions an individual trader could, just on a larger scale.

In times of worry, markets often move towards more assets considered more secure: traders often move away from exotic or minor fiat currencies into majors such as the US dollar (USD), Swiss franc (CHF), or Japanese yen (JPY) or into precious metals such as gold and silver.

Greed on the other hand, sometimes manifests itself in commodities markets. Organisations, countries, and companies are deciding to limit the supply of precious goods (such as crude oil, natural gas, or even diamonds!) to maximize their profits and apply pressure to markets, or even drive the narrative in geopolitics.

As human beings we have emotions. When it comes to trading financial markets though, putting them aside and keeping them away is usually your best bet, as they could affect your judgment and affect your trading style.

The most common emotions a trader might deal with are:

Fear

• Can stop from placing a trade
• Can push to hold onto a losing trade, stopping from cutting further losses.
• Can push to close a profitable trade before the set goal

Greed

• Can lead to keeping a position open even though the expected gain was already achieved exposing it to market swings.
• Can trick to move your Take Profit order further exposing it to trend reversal.
• Can lead to using too much margin at once or trading too much.

Hope

• Can lead to following the advice of others blindly.
• Can coexist with fear or greed exposing to keep losing trade open in the hope of recovery or pushing to hold onto a profitable trade until it is no longer one.

Regret

• Can lead to accepting more risks because our risk appetite led previously to not placing a successful trade.
• Can result in abandoning trading strategy because it did not lead to gains others executed.
• Can push to trade like other successful traders instead of forming a strategy.

Trader’s ego

• Can lead to false assumptions we are always right about the market.
• Can result in relying on a hunch and not having a strategy.
• Might be a reason to lose easily.
• Can stop considering trading risk and having a risk management strategy.

An example of fear can be seen at market bottoms; as the price of an asset falls sharply and a downtrend begins, fear begins to build up gradually, and as the price continues to decline, fear reaches an extreme level, which in some cases can be used as a contrarian indicator. The above chart highlights multiple instances where price action may have reflected fear. The highlighted candles are hammer formations that follow a downtrend; as the downtrend gets exhausted, the final leg of the downtrend is where fear reaches its peak, forming a hammer candlestick pattern, and some contrarian traders may consider it an opportunity to enter the market and take advantage of a lower entry price.

Hammer candlestick patterns reflect that sellers' activity took the price down to low levels during a trading session; however, by the end of the session, prices rose and closed at a relatively higher level than their session lows. Candlestick patterns should not be analysed independently, which could lead to false signals. However, they can be used with other tools and indicators to filter out false signals.

Now that you have learned more about the emotions that can hold you back in your trading, find out about the key habits of successful forex traders.