Applying Trading Psychology to Enhance Trading Success

Trading Psychology and NLP

Much has been written in recent years about the importance of trading psychology, but very little has been offered on how to apply the principles in trading practice. In this article, we will review key principles of trading psychology. We shall explore how you can apply trading psychology in combination with the trading systems you have learned, developed or chosen, to enhance your trading performance. Generally, in western cultures people are exposed to very little information or training in how to manage their psychology. In addition, many people have no idea about how their emotions function nor how to work with them effectively to manage their behaviour and lives. This is equally true for the specialised area of financial trading. The need for effective self-management in the trading context becomes apparent as soon as the novice trader begins their journey towards becoming an effective and successful trader. They encounter the emotional vicissitudes of exuberance, fear, panic, hesitation, greed and regret. They may realise that their emotions affect their trading performance. Unfortunately, some novice traders come to believe that if only they could be detached from their emotions that their trading performance would improve. That is an unfortunate misunderstanding. Emotions, when understood and utilised can create the edge to performing well in the market. Our emotions are sophisticated forms of cognitive processes. They are part of our evolutionary development and have, using a term found in evolutionary psychology, ‘adaptive benefit” for our species. Emotions can be utilised, managed and can be of great benefit for trading success.

We prefer to use a broader term than emotions. We refer to ‘states’. A state is simply a combination of a person’s thought processes, posture and breathing pattern, attention and the neuro-organisation that they are experiencing in any particular moment in time. We are always in some state of mind. If you were to review your trading experiences, you will find times where you are performing well and in that successful experience, you have a particular state. You will also have experiences where you were in a particular state that was not conducive to your trading. We have found that high-performing traders, in addition to having a well-tested trading system, manage their states while trading so that they have an optimal state for their trading situation.

The Difference that Makes the Difference

So, what are the characteristics of expert traders? They have a tested trading system, a tested trading plan and excellent execution of their trading plan within the frame of organised risk and money management. To do all that well, they manage themselves and their states – their trading psychology.

In this article, we will draw on research in psychology, especially a sub-discipline within cognitive psychology that studies expertise and expert performance. We will also draw on the developing understanding about the relationship between mental process and changes in people’s neurology; an area of psychology known as neuro-cognitive psychology. We will connect this information to how our emotions function, habit formation, the development of expertise and how this applies to developing oneself as a successful and expert market trader.

In the last 15 years, there has been a growth in the study of expertise and expert performance. This has led to a developing understanding of the patterns of behaviour engaged by people who become expert in their particular domain. The first pattern that I want to explore is the use of practice to form a habit. As a species, we have a wonderful ability to automate any pattern of behaviour and a collection of behaviour patterns to create a skill. Automation of behaviour allows us to do complex skills without conscious effort and frees our limited attention for other matters. Free attention can be shifted to other information and variables that may be useful for our performance and success. A classic example that most people have experienced is learning to drive a manual car. When we first begin the learning process it takes most of our conscious awareness to attend to all the different actions involved; where we are on the road, steering, the co-ordination of the clutch, the accelerator and the gear lever. On top of all that, we are listening to the instructions of our teacher and the sound of the engine and the feel of the car so that we can know when to change gear. This is taxing on our limited attention and yet with practice, the component behaviour and the relationships between those components automate and integrate into a (hopefully) high level skill at driving. Once we have automated driving, our attention is free to attend to the important factors of the conditions on the road and the behaviour of other drivers (the context). Note that I have emphasised the word relationship in the previous sentence. Each piece of information that we need to attend to and each relationship between those pieces of information takes up a slot of attention. The limits and engagement of conscious attention when learning something new is an area of cognitive psychology called cognitive load theory. This is part of a broader area of research called human cognitive architecture, which is the study of conscious attention, unconscious processing and the relationship between the two. I would hope that as a trader or someone interested in trading, that your thoughts have turned to the experience of learning to trade. Like any skill that takes expertise, there are multiple patterns of attention and behaviour involved in the process of trading. When learning new skills, those multiple patterns can tax your available attention creating excessive cognitive load (too much to remember at once).

As we are in the business of developing or enhancing expertise in trading the markets, it is time to elaborate on cognitive load theory. For most people, our conscious attention is limited to between five and nine ‘chunks’ of information for novel material itself and the relationships between separate elements of it. This uses our short-term memory, nowadays referred to as working memory, to hold the new information, as there is little relevant material in previous experience to draw on. A chunk is the largest meaningful unit that a person recognises in the learning context. As information and patterns of behaviour are internalised, when the information goes into long-term memory, it can be drawn upon and used to augment what is in working memory. This is when conscious attention is freed up for new information. The process of organising information into bigger chunks is called ‘chunking’. If I give you eight digits to memorise, 9-3-2-8-2-9-9-3 this will fill most of your seven plus or minus two chunks of attention. However, if you group those digits into larger chunks, 93-28-29-93 you now have four chunks of two digits each. You could re-chunk the digits into two chunks of four, 9328-2993 by using mental rehearsal. If I add 02 on the front of the sequence so that we have 02 9328-2993, some of you will recognise the digits as a telephone number for Sydney, Australia. That telephone number is still only three chunks and well within your working memory capacity. This example is something we all do in our everyday lives. We chunk telephone numbers to support memorisation and easy recall. One of the keys to learning complex skills and developing expertise is to streamline chunking the patterns we need to automate.

We stated earlier that when learning new material, each chunk of information takes up a slot of our seven plus or minus two capacity for conscious attention. In practice, our attention is even more limited! Every relationship between chunks that we need to ‘hold’ in consciousness also takes up a slot of attention. This is why children sometimes have difficulty learning algebra. They need to hold each symbol in consciousness along with the relationships between the symbols to form a conscious understanding. The way the teacher presents the material and orders and sequences the information has a direct bearing on the ease of learning the child will experience with the material. You can see from the above examples that cognitive load is an important issue for teachers and learners of trading.

How does this relate to forming useful habits for developing trading expertise? We recommend taking the key patterns that make up trading expertise and practicing one or two patterns at a time until they are internalised and automated into long-term memory. This brings us to another important discovery in the sub-discipline of expertise and expert performance. It is commonly stated that ‘practice makes perfect’. This is untrue. In fact this saying needs to be corrected to read ‘perfect practice makes perfect’! If you practice a pattern that is incorrect, all you are doing is automating a poor pattern, which will lead to a bad habit that produces poor results. The development of expertise is accelerated if the key patterns used by other experts have been recognised, captured, described and then chunked appropriately for transfer. This is achieved through teaching or coaching to the person who requires development of expertise for that domain. When you have a set of expert patterns to practice until they are automated, this speeds up the development of expert performance.

In this paper, we will be presenting some of the key patterns of expertise in trading psychology that we teach on our programs. When you practice these patterns in a disciplined manner (regularly, for short, concentrated sessions, with full attention) you can development expert performance in your trading psychology, which you can apply in combination with whatever trading system you have learned.

In previous articles, we described a series of emotions (states) that both novices and to a lesser extent, traders with more experience may encounter at different stages of trading. Irrational exuberance can occur when a trader believes that he or she has found a winning pattern and placed a trade. Fear may be experienced when you suspect the market is going to turn during a trade. Hesitation can happen when you have found one or more patterns that point to a trading opportunity and that trade would fit with your previously developed trading plan. Greed can lead to you put substantially more money into a trade even though to do so goes against your trading plan. You might trade to get revenge for having taken one or more losing trades and of course, you can regret having not taken a trade that would have been good or having placed a losing trade.

The Structure of Emotions

States have patterns and structure. Just as we find patterns when looking at a chart, we can find patterns in the operation of our psychological states. Every state that you experience operates in some context. It involves a sequence of thought, (this happens very quickly if the particular state is a well practiced one – a habit); it relates to matching some standard or criterion that you hold about your experience and it involves your attention. We instruct seminar participants in how to reactivate a state and how to de-construct it into the component patterns of that state. It is useful to develop awareness of when particular states occur while trading. Then you can establish how the state is organised as a pattern and the personal criteria are involved. This prepares the trader for changing that state if it would be useful or necessary. Then the trader can have access to states that are useful for each particular stage of the trading process. We use our knowledge of cognitive load in designing and sequencing exercises, so that traders have the opportunity to develop understanding of how their states operate. Then they can apply this knowledge to their trading contexts and learn to reorganise particular states so that their emotions support their trading success rather than hinder it.

So what is the first step in learning to manage the states you experience when trading? We start with recognition. It is useful to review a number of your successful and unsuccessful trades. The criteria I suggest that you use for deciding whether a trade is successful or not is whether you followed and executed your trading plan. Your trading plan should include your entry and exit criteria, the percentage of your trading account that is placed on each trade and clean execution. What states do you experience when a trade goes to plan? What states do you experience when you make a profit on a trade? And what states do you experience when you make a losing trade? By taking an inventory of your trading states on a regular basis you can discover what states you experience and under what conditions. This feedback is the basis for beginning the process of reorganising your states, so that you have the right type of states for each stage of a successful trade. A trading state audit provides you, the trader with a baseline for utilising the emotion part of your trading psychology.

A second step in managing trading states is learning to shift in and out different states consciously. Once a state is recognised and defined, it can be interrupted. In general, people are not aware that they can learn to track their states as they experience them and put themselves in a different state deliberately, when that is useful for influencing a particular situation. Having the facility to choose the state you want to be in while trading can make a significant difference to your trading success.

Another step in working with state is the relationship between emotions and risk management. We have designed and tested a process where traders explore the emotional and trading behaviour responses they experience under different risk conditions. In addition to emotion, other factors of interest include changes in trade size, the percentage of your account that you place on a trade. Understanding your relationship to risk is a fundamental for good trading psychology.

So far, we have addressed the management of problematic states that occur too often for many traders. Now we shall shift attention to the development and activation of high performance states to support useful trading behaviour. In recent years, a new area of psychology has been developing that studies the apparently naturally occurring states that successful individuals experience when performing with excellence. Common examples are found in the world of sport but this extends to any domain where exceptional individuals perform outstandingly well. You may have heard of golfers referring to being in “the zone”. Another common term for this type of state is “flow”. We will simply use the term “high performance state” (HPS). You may have had experiences of high performance states yourself. Can you think of an experience in some part of your life where what you were doing just flowed? If you were presenting, you found yourself with just the right words and responses. In a team sport, you found yourself in the right place at the right time, acting with dispatch with the ideal responses to the situation. If you examine examples of situations where people experience high performance states, you would find some common features described by these people about such states. High performance states occur in challenging contexts. There has to be enough challenge to engage the attention fully, but not too much. People’s attention is in the present. No thoughts are concerned with the past or the future. People report an absence of self-consciousness and a lack of self-talk and some report peripheral awareness with their visual attention. In all examples the individual has a through understanding of the content area where they are performing and they are using a well rehearsed skill. Fortunately, people can learn to access and activate high performance states when they want to. We have specific exercises expressly for the purpose of creating and activating such states. Activating high performance states for the trading context ensures that you use your trading system well with good timing and flow in executing your trading plan.

Beliefs and Intentions

One final area that we will address in this article is that of beliefs and intentions. Simply put, expert traders have beliefs that support good trading behaviour. Limiting beliefs about personal capability, self-value, and self-concept can lead to poor state management, low performance behaviour and trading failure. It is important that traders develop an awareness of the beliefs they carry about themselves, their relationship to money and to the business of market trading. It is useful to consider what your intention is for trading. What do you expect to achieve through trading and what do you believe about yourself in relationship to trading? Expert traders often have very different intentions from those of the average trader. Experts are not just in it for the money. Profit is perceived as a measure of skilled pattern recognition, self-management and management of the trading process. We recommend that traders take an inventory of their intentions and their beliefs. Having that awareness is the first step to challenging and changing insupportable beliefs. Limiting beliefs can be changed to useful beliefs that are generative and support expertise in trading behaviour and importantly that includes trading psychology.

Whatever the trading system you use, developing and applying trading psychology can significantly improve your trading success.

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