Have you ever felt your heart racing as you watched a crypto holding soar, only to be gripped by panic as it plummeted the next day? Whether conscious of it or not, this rollercoaster of emotions can influence your behavior and, ultimately, your success as a trader.
By understanding the insidious role of fear, greed, and other emotions on trading decisions, you can proactively implement strategies that remove them from the equation. As a result, you can reduce psychological stress and improve your performance.
In this guide, we’ll dive into how cognitive biases impact trading and three actionable strategies you can use to take control over fear and greed.
How Cognitive Biases Impact Trading
Fear and greed have their roots in human psychology and physiology. When we perceive a threat, our body releases adrenaline that causes us to become anxious and panic. Conversely, when we see a potentially meaningful opportunity, our brain releases dopamine, leading to euphoria and excitement. These emotional responses often manifest in the form of fear and greed.
Fear often manifests as a “loss aversion bias”: Many people prefer to avoid losses over acquiring the equivalent gains, even though they’re economically equal.
From an evolutionary standpoint, the loss aversion bias makes a lot of sense. An early human hunter, on foot and armed with a spear, would do everything possible to avoid harm to himself, knowing that if he were injured or killed, his children would suffer.
However, these tendencies can become problematic when trading cryptocurrencies. Researchers have consistently found that traders across every asset class tend to hold on to losing positions for much longer than winning trades based on their fear of realizing their losses. But, of course, the irony is these habits lead to the very outcomes we fear will materialize!
The same instinct that protected our ancestors can be devastating to traders.
Greed arises from a variety of cognitive biases. For example, the “gambler’s fallacy” is the tendency to think that a trade will go a certain way based on past performance – even though there’s no evidence to support that rationale.
For example, you may have seen a friend make a ton of money on Dogecoin ($DOGE), which led you to follow their advice on a different initial coin offering even though there’s no data to suggest they will be any more successful on a second investment. Or, you may have seen one initial coin offering soar in value and try your luck on the next one you see without further investigation.
Again, the gambler’s fallacy may have been helpful from an evolutionary standpoint since animal patterns and growing seasons are cyclical. If you hunted in one area last autumn, there’s a good chance that animals will return the following year. But in financial markets, assets don’t always follow simplistic patterns (although they may follow more complex ones).
Other Cognitive Biases
Fear and greed aren’t the only cognitive biases that negatively impact trading performance. For example, “herd mentality” can encourage you to follow the crowd at the expense of your better judgment, just as “anchoring bias” might make you latch onto a single piece of information rather than considering all the potential confounding factors.
Of course, not all cognitive biases are negative. Some could have a negative impact, but eventually, they could lead to faster decisions that are better in the long term. Some cognitive biases may be impossible to counter because they’re a by-product of our information processing limitations.
The good news is that there are several strategies that you can use to mitigate the impact of negative cognitive biases – and we’ll cover those in the next section!
How to Overcome Fear & Greed
Removing emotion from your decision-making process can help you avoid the negative impacts of fear and greed. But, of course, making decisions against your “gut” feelings is complicated and requires a lot of discipline and practice to master.
Start with a Trading Plan
Professional traders often say, “Plan your trade and trade your plan.”
A trading plan can help you remove emotion from trading by deciding how to handle different scenarios ahead of time. For instance, you might have a process for sizing a position (determining how much to invest) and exiting the position (at a gain or loss).
You may also commit to a specific approach to find new opportunities. If you use technical analysis, you might focus on a particular chart or candlestick pattern and then fine-tune the entry and exit criteria to improve profitability over time.
Finally, rather than blindly jumping into new opportunities, a trading plan can also help you focus on achieving specific outcomes. For example, you might focus on reducing risk (reducing your average drawdown) rather than increasing profit (increasing average gains).
A trading plan should be a living document you put onto paper and update over time.
Lower Your Trade Sizes
The easiest way to reduce the emotional effect of a trade is to reduce its size.
You’re far less likely to make a poor decision with an extra $100 than you are with your monthly mortgage payment on the line. So, even if you don’t go through the exercise of creating an entire trading plan, reducing your trade sizes can help stop emotions from creeping into decisions.
As an added benefit, by taking this approach, you’re also making a lot of small trades rather than taking a single large bet, resulting in more diversification and opportunities to practice your trading strategy. And that can help reduce risk and improve performance.
Keep a Trading Journal
Management expert Peter Drucker once said, “You can’t improve what you don’t measure.”
Simply put, a trading journal is a log you use to record your trades. You can use the journal to reflect upon previous trades and evaluate performance. How many times did you violate your trading plan? How can you tweak your plan to improve performance or reduce risk?
If you use multiple brokers, ZenLedger can help aggregate your transactions in one place so you can go back and easily fill out your trading journal. Using the Recent Transactions tab, you can see the date and underlying asset for each trade to help you avoid missing a beat.
You can also use tools like TradeZella or TradesViz to quickly visualize helpful key performance indicators like your win/loss ratio, average win or loss amount, and cumulative net profit or loss. The movement of these metrics over time can provide great insights into your strategy.
The Bottom Line
Fear and greed play a central role in trading success. While you can’t always control your emotions outright, you can develop trading rules to systematically follow and track your performance over time to reduce their impact. Or, you can start by simply reducing the size of each trade to a non-emotionally-triggering value!
If you trade cryptocurrencies, ZenLedger can help you organize everything for tax time. Our platform automatically aggregates trades across wallets and exchanges, computes your capital gains and losses, and generates the paperwork you need to file.
The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.