In this post you'll learn about investor psychology and the psychology of trading - this post has been updated, over time, so it provides insight during the market crash of 2020 and the stock market decline of 2022.
August 2023 Important Note: It's important to mention that this was written BEFORE I used pro active hedges into my trading strategy. Not only do I trade a lot of defined risk trades, but I also use pro active hedges. By doing this, I'll sacrifice a few percentage points of profit during a bull market to dramatically outperform during a bear market. It's vital to always think long-term when investing - just because the market is up ~20% in YTD 2023 does NOT mean that this will continue. As Warren Buffett says, "Be fearful when others are greedy, and greedy when others are fearful."
As much as the fake gurus want you to believe that you're going to make money every day, remember that there is no easy money when trading options and you'll have bad times when investor psychology / the psychology of trading will become challenging.
There are ups and downs. The emotional toll of being a trader can affect you if you're not prepared.
How will you react if the market crashes 10% in a few days? This isn't common, but it's happened before.
When it happens it can lead to massive stress, anxiety and depression.
Will you allow the psychology of trading to leave you depressed and anxious?
Remember that the pain of losses are much stronger than the happiness from gains.
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In late 2018, I experienced a ~10% decrease in my account over 2 months.
I've had this happen before.
When it does happen, I've learned how to get through it without letting it affect me (August 2023 update - it's best to use pro active hedges to mitigate drawdowns and portfolio volatility).
The reason I was able to maintain confidence is because, based on my prior experience, I knew that I'd recover from it.
No one ever wants to lose money trading. The good news is, if you know how to maintain positive trading psychology and investor psychology, then you have an excellent chance of recovering from your losses.
Market Volatility Affects Your Trading Psychology
When it comes to trading and consistently making money, you have to bend and not break during a market correction.
Before February 2018, I made money every month for almost ~2 straight years by selling premium (yes, this is true and it's pretty spectacular reflecting back on it in 2023. I remember waking up on Monday morning with an expectation, almost as a given, that I was going to make $20,000 this week in trading profits).
I got used to always making money. Perhaps, I even took it for granted.
Yet in 2018, I incurred losses in a few months.
The last quarter of 2018 was treacherous and I lost 10% of my account.
When I lose money, maintaining positive trading psychology is difficult (August 2023 Note: it's much less difficult when hedging your portfolio so that those pro active hedges can eliminate that 10% loss, or even turn that loss into a gain).
Yet, during these times, the psychology of trading becomes even more important.
While incurring losses, I began to get a little depressed, I was slower in getting things done and I had less energy.
While going through a difficult time, you don't know that things are going to improve (August 2023 Update: yeah, this still rings true. The future is unknown so it's best to try to reduce anxiety and stress in the present moment).
Instead, you're looking at your account and see that the hard-earned money that you've earned has been lost.
That's a horrible feeling, but you should always expect market fluctuations when trading.
I have ~20 years of trading experience yet I do everything possible to minimize losses because the stress is very unhealthy.
I would rather make less during the good times to ensure that I lose A LOT less during the bad times (August 2023: This is probably one of the most important points. People feel uncomfortable putting on pro active hedges because it decreases their performance during a strong bull market. They chase the gains and exchange an additional ~2% upside for 20% downside - what they are unable to realize (or unable to execute upon) is that by being fearful when others are greedy, they can dramatically outperform the market!
Having Healthy Investing Psychology is Essential to Success
You will not win every single trade and if you want to trade and earn consistent profits then positive trading psychology is very important.
Having discipline and patience is also very important.
When experiencing losses, I had complete 100% certainty that I was going to make all the money back.
In fact, in late December and early January 2019, I made back almost everything that I had lost.
You should always consider investor psychology when evaluating strategies.
Trading the stock market can be volatile.
Selling option premium is definitely the best stock market trading strategy.
But can you handle the psychological stress that goes along with losing money?
Investment Psychology: Is Trading Right for You?
You have to know yourself well enough to make the decisions that are best for you.
Remember that the higher the return you seek, the more risk you'll assume. For example, many people who try to turn $5,000 into $500,000 end up losing everything.
I highly recommend that you visualize yourself losing 10% of your account and experiencing the emotion that comes with it. Mental visualization is very powerful and can help prepare you so that you don't become a slave to your emotions.
If you feel that you're someone who will not handle volatility swings well, then it's best to take on less risk (trade spreads, buy protective puts, etc.)
Prepare yourself ahead of time and know the risks with positive investor psychology.
That way, you'll be prepared.
Remember that there is no easy money.
And despite knowing the best way to trade, which is trading options and collecting premium, it's important to realize that you won't win all of your trades.
Selling option premium is the best way to consistently make money in the stock market, but you have to learn how to hedge your positions because options are leveraged products and you need to mitigate the tail risk.
I teach the best way to mitigate risk in the Options Trading Education Course at https://beststockstrategy.com/memberships/
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Trading Options Provides Consistent Income But There's No Free Lunch
While you'll likely always lose money by day trading, selling penny stocks and trading forex, be aware that even options traders who sell premium will experience volatility in their returns.
You will have good months and bad months.
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Selling option premium allows you to be consistently profitable, but you're not going to win every trade.
There is volatility, but you can learn how to mitigate and reduce the portfolio volatility.
Options trading requires discipline, and there is no easy money for traders or investors in the stock market.
There will be volatility when trading.
You can mitigate the risk by trading vertical credit spreads and by hedging your positions.
I prefer trading naked options because it provides more freedom to roll / manage the position while reducing the strike price. (August 2023 Note: I now prefer vertical credit spreads and defined risk trades).
"Investor psychology is extremely important. If you are unable to handle swings in volatility, then it's best to use proactive hedging strategies to mitigate your portfolio volatility." - David Jaffee, BestStockStrategy.com
2020, 2022 and 2023 Option Trading Strategy Adjustments
It's important to reduce portfolio volatility while trading.
During periods of low volatility it's important to buy options to reduce volatility during times when the expectation volatility is less than the actual volatility.
I also believe it's worthwhile to buy stocks that are oversold.
For example, in 2022, Amazon was trading around $100, this represented a ~40% drop from its recent high.
Buying AMZN shares provided significant upside potential.
Traders can even buy calls during periods when the market is believed to be oversold (for example, when AMZN traded below $85).
While I understand the probability of profit when buying calls is less than 50%, the reality is that sometimes the stock market becomes oversold, or overbought, and during these periods, it's important to buy options to reduce volatility while also being able to participate in the upside moves.
Also, while the expected probability of buying options is negative, there are times (for example when AMZN fell below $85 / share) when the risk / reward makes the trade worthwhile. When everyone is fearful of a great company, then it's usually worthwhile to step in and go long (either by selling puts, buying calls or buying shares).
Conclusion: Positive Psychology of Trading / Trading Psychology is Vital to Success
Stock market trading is not easy. Remember that some options strategies are better than others.
The best way to be successful with stock investing is by selling stock option premium.
I can teach you about call options, put options, credit spreads & options strategies so that you're consistently profitable.
It's important to think long-term when trading and investing, that's what really matters.
While there is a major emotional toll that goes along with trading losses, you can mitigate the portfolio volatility easily.
It also helps to internalize that success is not easy: there are going to be ups and downs.
Play the long game and don't get discouraged by temporary setbacks.
Make less during the good times so that you lose a lot less during the bad times.
Thanks for reading. This was yet another long article. If you made it this far…you are a champ! And don’t forget to leave a comment below. I especially want to hear dissenting opinions. I look forward to reading your comments!
Frequently Asked Questions (FAQs)
What's the best way to deal with trading losses?
The best way is to reduce portfolio volatility by not trading too large and by buying options during periods of low volatility and when you feel that the market may be oversold.
How to recover from large trading losses?
Learn from your mistake so that you don't repeat it and slowly build back up your account. Losses hurt significantly more than the gains feel good. Do not gamble, it's not worth it.
How to deal with a losing streak?
After a losing streak, start small; don't jump right back to the same position size you were trading before. During the first month or two, trade smaller position sizes.
But, most importantly, try to avoid taking big losses. This requires you to BUY options during periods of complacency and when the market is oversold.
What are some of the biggest trading losses?
OptionSellers blew up their $150MM hedge fund. Long-Term Capital Management received a $3.6 billion bailout.
There are numerous traders , or institutions, who have lost money - they usually lose money because they get complacent, trade too large and do not have proper hedges in place.