TRADING PSYCHOLOGY: UNDERSTANDING THE ROLE OF

HUMAN BEHAVIOUR IN FINANCIAL MARKETS

Nitin Chadha1, Dr. Indresh Pachauri 2
1Research Scholar, Glocal School of Business & Commerce, The Glocal University,
Mirzapur Pole, Saharanpur (U.P)
2Assistant Professor, Glocal School of Business & Commerce, The Glocal University,

Mirzapur Pole, Saharanpur (U.P)

Abstract:
Trading psychology plays a vital role in financial markets, as the decision-making process of
traders is influenced by a range of psychological factors. This research paper aims to provide
an in-depth analysis of trading psychology, exploring its impact on trading decisions, risk
management, market trends, and overall market stability. By understanding the psychological
drivers behind trading behavior, traders and investors can enhance their decision-making
processes and develop strategies that align with market dynamics. The paper also discusses
various psychological biases and heuristics that affect trading outcomes and proposes
potential approaches to mitigate their negative effects. Ultimately, this research paper
emphasizes the significance of incorporating trading psychology principles into market
analysis and decision-making strategies.
____________________________________________________________________
Understanding Trading psychology &Human Behaviour

Trading psychology encompasses the psychological factors and emotional states that influence
a trader's decision-making process in financial markets. While technical and fundamental
analysis are essential, traders must also understand and manage their emotions, cognitive
biases, risk tolerance, and discipline to succeed in the markets. This chapter delves into the
intricate aspects of trading psychology and provides insights into how traders can develop a
mindset conducive to consistent profitability.

The Role of Emotions in Trading:

Emotions, such as fear, greed, and hope, can significantly impact trading decisions.
Understanding the role of emotions in trading is crucial for maintaining objectivity and making
rational choices. This section explores common emotional challenges faced by traders and
offers strategies to manage emotions effectively, including mindfulness techniques, emotional
awareness, and risk-reward analysis.

Trading psychology and emotions are closely intertwined in the world of financial markets.
The decisions made by traders are often influenced by their emotional state, which can

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significantly impact their trading performance. Understanding the role of emotions in trading
and learning how to manage them effectively is crucial for achieving success and maintaining
a disciplined approach.

Emotions play a central role in the decision-making process of traders. Fear, greed, hope, and
excitement are among the common emotions experienced while trading. Fear of losing money
can lead to hesitation, missed opportunities, or irrational decision-making. Greed can result in
excessive risk-taking or holding on to losing positions. Hope and excitement can cloud
judgment and lead to impulsive trades. Recognizing the impact of emotions on trading is the
first step towards managing them effectively.

Let us understand this with the help of an example:

A trader who trades on intraday basis entered a trade in morning and made a profit of Rs. 2000.
Now, his confidence has reached to a level where he considers himself as great profitable
trader. His eyes will look for patterns and signs that are not present. After some time, the charts
will start to build in his mind. He will start to forecast the market and will punch in a new trade.
In back of his mind, he absolutely knows that he has punched the trade without confirmations.
And now his mind will start to look for confirmations for the trade he has already punched.
This is called confirmation Bias. If the required conformation is not available, he will look for
websites, news columns etc to support his theory of extra trade he has punched. This is where
Availability Bias comes into picture. Now, if the trade goes into profit, well and good. It will
lead to overconfidence. However, if the trade went south, which it will in high chances, his ego
will come into play, which will ask him average the trade at lower levels. His mind will start
to look for all the reversal signals and signals. The losses will pile up from over trading and
averaging to an extent where the trader will lose his calm. Soon enough, he will be trading in
a quantity which is beyond his limits. At the end, he will or his broker will cut his trade in deep
loss. Anxiety, depression is all he will get at the end. This is typical day of an undisciplined
intraday trader who trades on tips and news.

We all must have heard stories of various traders making profits initially but then ending in
losses. Over trading or rather revenge trading, emotional thinking, FOMO are some common
challenges most of newbie traders experience in markets. Let us understand them all point by
point.

First and foremost, most of the traders do not have a clear goal or vision towards markets.
Most of them do not know what they are getting into and what they want from markets.
Secondly, we fail to understand and acknowledge the fact, that we are playing or fighting
against big money whose capacity to invest or bear loss is beyond our imagination. As per
latest NSE report, India markets score highest in terms of F&O turnover. The average daily
F&O turnover is somewhere INR. 247 lakh crore. 247 lakh crore!!!!!!!!!!!!!!!

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How can a retail trader think of even fighting against this figure? Here comes mindset into
picture. As in intraday trader it important to set limit to profits or losses as the case may be,
and move on for next day. Markets are invincible and going to stay for indefinite future. There
is always a tomorrow. If I save today, then only I will be able to trade tomorrow. Most of the
retail traders are unable to gauge their downside and thus exit the markets cursing. What we
fail to understand that trading is art as well as science. Like any other business, trading also
require certain set of skills where mindset plays and extremely important role. Why it is said
that 99% of traders or investors entering the markets end up making losses and only 1% of
them sail through. Trading Financial markets is a Zero sum game i.e. some one’s loss is some
one’s profit. In this research let’s try to peal the role to emotions and mindset layer by layer
and ways in which we can make our emotions our best friend.

Markets have immense opportunities for everyone. Be it a trader with extremely small capital
or a trader with a huge capital have one thing in common i.e. emotional play.

Common Emotional Challenges in Trading:

Traders face a range of emotional challenges that can affect their trading performance. These
challenges include fear of failure, anxiety about market uncertainty, frustration from losses,
and stress from the pressure to perform consistently. Additionally, overconfidence and
euphoria after successful trades can lead to complacency and taking unnecessary risks.
Understanding these emotional challenges is crucial for developing strategies to overcome
them.

Cognitive Biases and Trading:

Cognitive biases are systematic errors in thinking that can distort a trader's judgment and
decision-making. Techniques such as diversification, critical thinking, and self-reflection can
help traders overcome cognitive biases.

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Cognitive biases are inherent patterns of thinking that can affect decision-making and
judgment. In the context of trading, cognitive biases can lead to irrational and biased decisions,
impacting trading performance and profitability. Recognizing and understanding these biases
is crucial for traders to make objective and rational choices. This essay explores some common
cognitive biases in trading and provides strategies to mitigate their impact.

Confirmation Bias:

Confirmation bias refers to the tendency to seek out information that confirms preexisting
beliefs or biases while disregarding contradictory evidence. In trading, this bias can lead to
selective attention and cherry-picking data that supports a particular trade or investment thesis.
To mitigate confirmation bias, traders should actively seek out opposing viewpoints, perform
thorough research, and remain open to challenging their own beliefs.

Availability Bias:

Availability bias occurs when individuals rely heavily on readily available information or
recent experiences to make judgments or decisions. In trading, this bias can lead to
overemphasis on recent market trends or news, overlooking historical data or other relevant
information. Traders should strive to gather a comprehensive range of information, including
historical data and different perspectives, to avoid being unduly influenced by availability bias.

Anchoring Bias:

Anchoring bias involves relying too heavily on the first piece of information encountered when
making decisions. In trading, this bias can occur when traders anchor their expectations or price
targets based on initial information or reference points. To mitigate anchoring bias, traders
should adopt a more flexible mindset, consider multiple data points, and reassess their
assumptions and expectations based on new information.

Overconfidence Bias:

Overconfidence bias refers to the tendency for individuals to have excessive confidence in their
abilities, leading them to overestimate their knowledge, skills, or predictive abilities. In trading,
overconfidence can result in taking excessive risks, failing to properly analyze potential
downsides, and disregarding risk management strategies. Traders should actively seek
feedback, maintain a realistic assessment of their abilities, and regularly reassess and validate
their trading strategies.

Gambler's Fallacy:

The gambler's fallacy is the belief that past outcomes influence future probabilities, despite
each event being statistically independent. In trading, this bias can lead to irrational decision-

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making based on perceived patterns or streaks. Traders should understand that market
movements are random and influenced by various factors, avoiding the trap of assuming past
outcomes will repeat in the future.

Herd Mentality:

Herd mentality refers to the tendency for individuals to follow the actions and decisions of the
majority, assuming that the crowd is correct. In trading, this bias can lead to chasing trends or
entering trades based on the actions of others, without proper analysis or consideration of
individual circumstances. Traders should develop independent thinking, conduct thorough
research, and make decisions based on their own analysis and risk tolerance.

Loss Aversion:

Loss aversion is the tendency to strongly prefer avoiding losses over acquiring gains of equal
value. In trading, this bias can lead to holding on to losing positions for too long or exiting
winning trades prematurely. Traders should develop a disciplined approach to risk
management, set clear exit criteria, and avoid making decisions based solely on emotions
associated with losses.

I believe most of the retail traders including myself, can relate to some of the bias that was
there in them in their journey of trading. But to become a successful trader one has to come out
of all these and perceive markets as a place of business and a casino. Everyone has listened to
one or another story of rags to riches. We all know see every trade we enter as the one which
will change the course of our trade. Hence, we try to look for patterns that are not present, news
that is not there, confirmations that are not there and then we cement our trades with this belief
which leads to unacceptance of failure in case it goes against us. Further, we average or we
hold on for too long and one fine day it’s all done.

Thus, Cognitive biases can significantly impact trading decisions and overall performance. By
recognizing and understanding these biases, traders can employ strategies to mitigate their
effects. Seeking diverse perspectives, remaining open-minded, conducting thorough research,
and implementing disciplined risk management practices are essential to overcome cognitive
biases. Developing a rational and objective mindset is crucial for traders to make informed and
successful trading decisions.

To sum it up, a professional trader should not have any bias towards a trade or his setup. If his
setup shows a signal, trade it else sit silently and let the trade come to you. There are various
techniques to overcome or mitigate several biases as discussed above:

• Develop a deep understanding of different cognitive biases and their potential impact
on trading decisions. By educating yourself about these biases, you can increase your
awareness and be more mindful of their influence.
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 • Avoid relying solely on a single source of information. Seek out diverse perspectives,
alternative viewpoints, and a wide range of data sources. This can help you challenge
your existing beliefs and prevent confirmation bias.
• Cultivate critical thinking skills to evaluate information objectively.
• Establish decision-making frameworks and rules that guide your trading strategy
• Maintaining discipline is crucial in mitigating cognitive biases. Follow your trading
plan rigorously, including predefined entry and exit points.
• Maintain a detailed trading journal to track your trades, decisions, and emotional states.
Regularly review your journal to identify patterns, biases, and areas for improvement.
Reflecting on past trades can enhance self-awareness and help mitigate biases over time.
• Engage with other traders or join trading communities where you can seek feedback
and different perspectives.
• Take regular breaks from trading to maintain emotional balance.
• Regularly evaluate and update your trading strategies based on feedback and market
conditions. Be willing to adapt and refine your approach as new information becomes
available.

Risk Management
Risk management is a fundamental aspect of trading in financial markets. It involves
identifying, assessing, and mitigating potential risks associated with trading activities to protect
capital and optimize trading performance. Effective risk management strategies are essential
for traders to preserve capital, reduce losses, and maintain a sustainable trading business. This
essay explores the key principles and practices of risk management in trading markets.
1. Risk Identification: The first step in risk management is identifying the various risks
involved in trading. These risks can include market volatility, economic events, systemic risks,
liquidity risks, and operational risks. Traders need to understand the potential risks specific to
the markets they trade and the instruments they use. By recognizing and acknowledging these
risks, traders can better prepare and develop appropriate risk management strategies.
2. Risk Assessment: Once risks are identified, traders must assess their potential impact
and likelihood. This involves evaluating the potential loss or adverse consequences that may
arise from each risk scenario. By assigning probabilities and estimating potential losses, traders
can prioritize and allocate resources to manage risks effectively. Risk assessment also helps
traders determine their risk appetite and set risk tolerance levels.
3. Risk Mitigation Strategies: Risk mitigation strategies are implemented to reduce the
impact of potential risks. Various techniques and tools can be employed to mitigate risks in
trading markets:

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 • Diversification: Diversifying the trading portfolio across different asset classes,
markets, and instruments can help reduce the risk of concentrated losses. By spreading
investments, traders can potentially offset losses in one area with gains in another.
• Position Sizing: Determining the appropriate position size for each trade is crucial in
managing risk. Traders should avoid overexposing their capital in a single trade,
limiting the potential impact of losses.
• Stop-Loss Orders: Placing stop-loss orders is an essential risk management technique.
A stop-loss order automatically exits a trade when the price reaches a predetermined
level, limiting potential losses. It helps traders define their risk in advance and ensures
disciplined risk management.
• Take-Profit Orders: Similar to stop-loss orders, take-profit orders help traders lock in
profits by automatically closing a position when the price reaches a specified target. It
enables traders to secure gains and avoid potential reversals.
• Risk-Reward Ratio: Assessing the risk-reward ratio for each trade is important in
determining if a trade is worth pursuing. A favourable risk-reward ratio ensures that
potential gains outweigh potential losses.
• Hedging: Hedging involves using derivative instruments or other strategies to offset
potential losses in one position by taking an opposite position. It helps mitigate the
impact of adverse market movements.
• Risk Monitoring: Regularly monitoring trades and market conditions is crucial for
identifying potential risks in real-time. Traders should remain vigilant and adjust risk
management strategies as market conditions evolve.
4. Emotional Discipline: Emotional discipline is a critical component of risk
management. Emotions such as fear and greed can lead to impulsive decisions, deviating from
predetermined risk management strategies. Traders must maintain emotional discipline and
stick to their risk management rules even in the face of market fluctuations and unexpected
events.
5. Risk Review and Evaluation: Periodic review and evaluation of risk management
strategies are essential to identify areas for improvement. Traders should assess the
effectiveness of their risk management techniques, analyze past trades, and learn from both
successful and unsuccessful outcomes. This continuous improvement process helps refine risk
management strategies and adapt to changing market conditions.
Let’s sum up all above in a practical example:
Let us assume Trader A has bought shares of ABC ltd at a price of Rs. 120 per piece. Now
there are three scenarios that will happen

• The stock will go up.

• The stock will go down.
• The stock goes in a sideways movement.

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Point no 1 and 3 are manageable and does not affect the emotions of a trader strongly. However,
if a stock stays in a sideways movement for a longer duration, the trader might feel his capital
being blocked and he could have earned a better return somewhere else. The problem starts
when stock prices goes south and they (trader) sees a negative portfolio value in his account.
Here the emotions and risk management comes into play. Either the trader/investor will book
in panic or will try to average out his price at lower levels. Only a disciplined trader will book
the loss at his stop out level and will look for further opportunities with his remaining capital.
The one who exited in panic was obviously the one who did not have any plan and traded on
hunch. The one who is averaging at lower levels was a trader who was trying his luck or was
taking a revenge with market by showcasing his ego play. Basically, he was not able to accept
the fact that how prices fell. This was very popular scenario with Yes Bank stock or Vodafone
stock for that matter. Investors/ traders kept averaging more and more at lower levels an in time
it became a “HOPE TRADE”. The stock price of yes bank fell from a peak of Rs. 404 levels
to an all-time low of Rs 5.65 level. Imagine the plight of an investor entered at all-time high
level and kept og either holding the stock or averaging the same at every dip. Imagine the kind
of loss he was sitting upon. It is pertinent to note that the stock price did not fell overnight. The
same took almost 2 years. There were ample indications shown by the price movement for
exiting it, but lack of knowledge, risk management abilities, biases made the poor investor
stuck in the trade.
So, in nut shell every investor should decide the amount of loss/risk he is willing to take. Once
that threshold is breached, exit no matter what. There is no place for Hope and Greed in
markets. If all wickets are gone, no matter how good a team is will have no opportunity to
score.
Thus Risk management is vital for traders in navigating the uncertainties of trading markets.
By identifying, assessing, and mitigating risks, traders can protect their capital and optimize
their trading performance. Implementing sound risk management strategies, such as
diversification, position sizing, stop-loss orders, and emotional discipline, allows traders to
manage potential losses and preserve capital. Regular evaluation and adaptation of risk
management practices ensure continued effectiveness in dynamic market environments.
Ultimately, successful risk management enables traders to achieve long-term profitability and
sustainability in trading markets.
Discipline and self control

Discipline is the bedrock of successful trading. It involves adhering to a trading plan, following
predetermined rules, and avoiding impulsive and emotional decisions. Developing discipline
and self-control can be challenging, but techniques such as goal setting, routine development,
and accountability can aid traders in maintaining discipline.

Discipline and self-control are essential qualities for successful trading in financial markets.
The ability to adhere to a well-defined trading plan, maintain emotional stability, and exercise

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restraint in decision-making is crucial for achieving consistent and profitable results. This essay
explores the importance of discipline and self-control in trading, the challenges traders face in
maintaining these qualities, and strategies to cultivate and strengthen discipline and self-
control.

The Importance of Discipline in Trading:

Discipline is the cornerstone of successful trading. It involves following a predetermined set

of rules and maintaining consistency in trading actions. Discipline ensures that traders make
objective and rational decisions based on their trading plan rather than succumbing to impulsive
actions driven by emotions or external influences. It helps traders stay focused, mitigate risks,
and execute trades with precision.

The Role of Self-Control in Trading:

Self-control refers to the ability to regulate one's emotions, thoughts, and actions. In trading,
self-control is vital for managing emotions such as fear, greed, and impatience that can lead to
irrational decision-making. Self-control enables traders to stick to their trading plan, exercise
patience during market fluctuations, and avoid chasing short-term gains. It helps maintain a
long-term perspective and resist the temptation to deviate from proven strategies.

FOMO
Last but not the least Fear of missing out, popularly known as FOMO plays a lot with or
emotions. We fail to understand the king of opportunities financial markets holds for us. One
good trade missed is far safe and better that 10 FOMO trades taken in the financial markets.
Here impulsiveness plays out a lot. FOMO tends to compulsively force a trader to enter a stock
either at all-time high or at the distribution of the market.
FOMO, which stands for Fear of Missing Out, is a psychological phenomenon that can
significantly impact stock market behavior. It refers to the fear or anxiety that individuals
experience when they believe they are missing out on potential opportunities or gains. In the
context of the stock market, FOMO can lead to impulsive and irrational investment decisions
driven by the fear of missing out on profitable trades or market trends.
FOMO can be particularly prevalent during periods of market euphoria, when there is a surge
in market activity and prices are rapidly rising. Traders may feel compelled to join the frenzy,
fearing that they will miss out on potential profits. This fear can lead to hasty investment
decisions without proper analysis or consideration of risks.
The influence of FOMO can be seen in various aspects of stock market behavior:

• Herding Behavior: FOMO often drives individuals to engage in herding behavior,

where they follow the crowd and invest in popular stocks or sectors without conducting

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 thorough research. This behavior can result in market bubbles and exaggerated price
movements.
• Chasing Performance: FOMO can lead investors to chase stocks that have already
experienced significant price appreciation, hoping to capture further gains. This
behavior can be dangerous, as it may result in buying at inflated prices and suffering
losses when the trend reverses.
• Overtrading: FOMO can also contribute to overtrading, where individuals make
frequent and unnecessary trades in an attempt to capitalize on every perceived
opportunity. Overtrading can increase transaction costs, diminish returns, and increase
the risk of making impulsive and poorly thought-out investment decisions.
To mitigate the negative impact of FOMO in stock market investing, it is important to
adopt a disciplined and rational approach:

• Develop a Trading Plan: Having a well-defined trading plan with clear objectives, risk
tolerance, and entry/exit criteria can help mitigate the influence of FOMO. Stick to the
plan and avoid deviating from it due to emotional impulses.
• Conduct Thorough Research: Make investment decisions based on comprehensive
analysis and evaluation rather than succumbing to FOMO-driven emotions. Consider
factors such as company fundamentals, market trends, and risk-reward profiles before
making investment choices.
• Practice Patience and Discipline: Avoid making impulsive investment decisions based
on short-term market movements or others' recommendations. Maintain a long-term
perspective and exercise patience in waiting for suitable opportunities.
• Utilize Stop-Loss Orders: Implementing stop-loss orders can provide a safety net by
automatically triggering an exit from a position if it reaches a predetermined price level.
This helps limit potential losses and reduces the impact of FOMO-driven decisions.
• Diversify Your Portfolio: By diversifying your investment portfolio across different
asset classes, sectors, and geographies, you can reduce the impact of individual stock
movements and avoid excessive reliance on a single investment.
• Stay Informed and Educated: Continuously update your knowledge about the stock
market and investment strategies. Stay informed about market trends, economic
indicators, and company news to make informed decisions rather than succumbing to
FOMO-driven impulses.
Overall, managing FOMO in the stock market requires discipline, rationality, and a focus on
long-term goals. By being aware of the influence of FOMO and implementing risk
management strategies, investors can make more prudent investment decisions and navigate
the stock market with greater success.
Conclusion
Trading psychology plays a pivotal role in one’s trading journey. Trading financial markets is
one of the most challenging business know to us. All the above points and factors discussed
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above goes hand in hand and they all speak out in an akin manner. Emotional control,
Discipline or Risk management are all different sides of one similar part of trading i.e.
Psychology. A strong mind set with emotional control is what required to survive. One should
be aware of his risk abilities and design his trading plan accordingly. Plan your trade and
trade your plan
References
1. "Trading in the Zone" by Mark Douglas:
2. "The Psychology of Trading" by Brett N. Steenbarger: Dr. Steenbarger,
3. "Mindset: The New Psychology of Success" by Carol S. Dweck:
4. "Trading Psychology 2.0: From Best Practices to Best Processes" by Brett N.
Steenbarger:
5. "The Daily Trading Coach: 101 Lessons for Becoming Your Own Trading
Psychologist" by Brett N. Steenbarger:
6. "Trading Psychology: A Practitioner's Guide to Mindful Trading" by Ari Kiev: Dr.
Kiev, a psychiatrist and trading coach,
7. "The Disciplined Trader: Developing Winning Attitudes" by Mark Douglas:

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