Do you know the one psychological danger in the market and how to avoid it? Trading is hard work! And mentally taxing. So what can you do to protect yourself? Get your emotions in check. Learning the technicals is easy if you put in the time and effort to learn but the hard part is getting your mind in check.
Between dark pools, bots, alternative trading systems, pump and dump schemes, we all know about the dangers lurking in the stock market.
There is one, however that silently lurks in the background, unconsciously undermining all your trading decisions.
And that my friend is you. Today I am going to show you one psychological danger in the market and the strategy needed to avoid it.
Have you heard of the term “homo economicus”? First proposed in 1836 in an essay defining the characteristics of political economy, it is a term many are not familiar with. I know I didn’t until I decided to dig deeper into the psychological side of trading.
In the financial world, Homo economicus is a term that economists use to describe a rational human being. It is a model for human behavior, characterized by the infinite capacity to make rational, sound decisions.
We assume we always think and act rationally when making trading decisions. But what about human feelings such as fear, avarice, joy, desire for control, and so on? It should come as no surprise that modern research has proved the theory of an economic man is a flawed model.
On the same token, who can guarantee that a trader will always be focused and not guided by his emotions? No one can. In fact, it would be as challenging to avoid trading feelings as to prevent a physical reaction to pain.
For the reasons mentioned above, many researchers argue a “more human” subject (that makes somewhat predictable irrational decisions) would provide a more accurate tool for modelling human behavior.
Your Brain and Bodies Reaction to Trading
Do you know what happens in the human brain of the trader who decides to press the buy or sell button? Well, here’s a little crash course in biology.
Researchers in the 1950s discovered that different parts of the human brain are responsible for the various tasks we do.
Take the limbic system, for example. Neuroscientists consider it to be the “emotional center of the brain.” All of our emotions, memories, and motivation comes from this dynamic area of the brain.
Luckily, our pre-frontal cortex exerts some control over the limbic system, so it’s not running rampant. Similarly, we attribute actions such as planning, judgment, and selection to this part of the brain. In other words, our financial decision-making; how cool is that?
Your Body on Winning
I could probably save my words here and tell you to head to Las Vegas, and you’ll know what I mean. For the person who just had a royal flush at the poker table, predictably, they’re happy.
In fact, it’s deeper than the surface reaction of hooting and hollering. When you win, the “pleasure center” or Nucleus accumbens of your limbic system is activated.
In turn, this activation releases the happy hormone, dopamine. The sensation of euphoria flows through the body, but it soon leaves.
Unfortunately, the brain longs for this form of reward, yet when it gets it, it quickly needs more. And the only way to increase dopamine is to increase your level of risk.
In turn, this makes traders more willing to take bigger or unwise trades. We, humans, are a predictable bunch.
Your Body on Pain
The flipside is fear which arises from amygdala and part of the limbic system of the human brain. It is here we examine situations of imminent danger.
Situations classified as dangerous cause increased alertness and a willingness to escape or defend oneself, or the fight or flight response.
It is interesting to note, as in the case of a threat, the brain distributes exactly the same hormones during a trading loss. Neuroscientists have also proven that a market crash triggers the same area of the brain as physical pain.
Interestingly enough, neural reactions in the brain showed that the suffering caused by a loss works exactly the same as the sensation of physical pain.
Protecting You From Yourself
All these emotions have the nasty habit of causing a trader to make poor trading decisions. I think the day would probably be much more relaxed trading day if one could easily switch to Homo economicus during trading hours.
You must know how to deal with your emotions and what steps you must take to achieve your trading goals. So no FOMO trading!
So What Is One to Do?
You must equip yourself with the right tools to be able to implement your trading strategy profitably in the long run. Tools such as a solid trading plan with strict entry and exit criteria.