When I am working with someone who is new to options trading, I always start with how to master trading psychology (followed by how to manage risk). You can find all the winning trades in the world, but if you cannot manage your emotions and keep greed and fear in check, you will not last long as a trader. (Keeping your fear in check is especially important to keep in mind right now as we face highly volatile market activity.)
In my early days as an options trader, I definitely struggled with my emotions. In fact, when I look back, it’s a miracle my portfolio survived.
What happens when you don’t manage your emotions or mindset
Back in the dot-com era of the late 1990’s, I turned a small four-figure investment into a really nice six-figure fortune.
I can’t take credit for being a smart investor back then. Instead, I let stocks run higher and higher. I was always on the lookout for the next big opportunity, and I played heavily on margin.
I owned every name in the book: Yahoo, Doubleclick, Infospace, CNet, and CMGI. In the course of three years, my account reached its peak. I was running on greed and hubris.
When the correction started to hit, my account got battered. Because I was leveraged to the hilt, it came fast and furious. Any small drop was magnified in my account. However, I couldn’t let go. My ego was too invested.
The biggest hit came in July 2000 with a stock named Broadvision. I had amassed 7,000 shares. One Friday morning, I awoke to find the stock down eight points. I was petrified. Turns out they lost a big contract, but it got worse. It closed that day down about $14, and yet I did not sell because I was sure it would turn back up. I watched it go down all day long.
At the end of the day, my then-wife said I was pale as death. I was down $100K on one stock in one day. It was terrifying. Coupled with losses taken a few short months ago, I was taken out of the game for a while.
I would never wish my experience on anyone, but I did learn how to manage my emotions and risk.
How to master trading psychology: keep greed and fear in check
Greed and fear are the two main emotions that all traders experience to some degree. If you want to master trading psychology, you must keep these two emotions in check.
Greed causes traders to take huge, unnecessary risks with their capital. When a trade is going well, they don’t sell when they have a profit. No – they double down and buy more options or shares.
Greedy traders also tend to hold onto a trade for far too long. As my story above shows, a winning trade can easily turn into a losing trade.
Now, greedy traders aren’t necessarily bad people. They are human and operate in a capitalistic society that says more is better. But it’s not. As soon as you have a profit, TAKE IT. That is how you stay in the game and grow your wealth.
On the flip side we have fear. Actually, we have four trading fears:
Fear of missing out (FOMO)
The emotion of regret stings more than anything, especially when others around you are riding a big win right to the bank. Instead of stewing, look for your next big trade.
Fear of loss
All of us have lost a lot of money in the past couple of weeks. It is not easy to accept losses, but they are part of the trading game. Once you learn to accept that, you can rise above this fear. The key is moving on and not reflecting on the loss for too long.
Fear of being wrong
This fear stems from a crisis in confidence. If you find that your system of trading is not working, you have to change it. Being wrong is not all that bad, but staying wrong is a major problem.
Fear of turning a win into a loss
When a win turns into a loss, sell it immediately. Move on and adjust your approach for the next trade – because there is ALWAYS a next trade.
So in short, here’s how to control greed and fear:
- Take a profit when you have one
- Adjust your trading strategy to ensure you have more winners than losers
- Don’t dwell on the past – look ahead to the next winning trade
And take a break if you need to. There is no shame in sitting on the sidelines to clear your head. Plenty of traders are doing just that in response to the current chaos.
Why you need to tune out “the noise”
The pundits, experts, and analysts who populate the business media are what I (and many others) refer to as “the noise.” They are not always reliable sources of information, as they have ratings to think about.
In a way, they are like the local meteorologist who is practically foaming at the mouth ahead of a big winter storm. Is it a blizzard that will have us stranded in our homes for days? Or is it a garden variety snow storm that will coat us in 4” of snow? The meteorologist’s excitement level is not a good gauge of what will actually happen.
Tune out the noise, and look at the charts instead. The charts – of indices and individual stocks – provide you with unbiased data. They will tell you what is actually happening in the markets.
If you master trading psychology, surprises won’t destroy you
Surprises from a breaking news story – like lockdowns at the beginning of the COVID-19 pandemic – or an unforeseeable, black swan event – like the 9/11 attacks in New York, Pennsylvania, and Washington, DC – can throw markets into instant turmoil.
This month, we are dealing with tariffs that seem to change every few days. We knew they were coming, but we didn’t know they’d be as nonsensical as they are.
Markets in turmoil wreak havoc on our mindset.
When a surprise rattles the markets, don’t panic. (Easier said than done, right?)
Remind yourself that the markets historically move up and to the right. In other words, they gain value over time. If you were to look at a 100-year chart of the S&P 500, you’d see that the Great Depression of the 1920s and the Great Recession of 2008-09 are small blips on the chart.
And as hard as this sounds: Be patient. When other traders are panicking, you can find once-in-a-lifetime trades. Even Warren Buffet said, “Be greedy when others are fearful, be fearful when others are greedy.”
When the markets dropped in March 2020, blue chip stocks dropped as well. Smart traders scoped up bargains like Apple and NVIDIA. Perhaps they sold them for a gain already, or maybe they are holding them for the long-term. Either way, the traders that embraced a calm and rational mindset saw their wealth grow – sometimes exponentially.
To protect your mindset, protect your portfolio
One way to keep a calm and focused mindset is to protect your portfolio by buying index puts. They are like insurance for your mental, emotional and financial health. My go-to’s are SPY, DIA, QQQ, and IWM.
Index puts don’t cost much, but I am so glad to have them as a hedge against volatility. They actually act as a cushion against wild swings in the markets. You may still suffer losses, but those losses will be much smaller. Likewise, they will dampen your earnings a bit.
Many people ask me how much to buy. That all depends on your risk tolerance, but my general advice is to have 3-5% of your portfolio invested in protective puts; continue rolling them forward. They will greatly reduce the overall volatility of your portfolio, and they will help you sleep better at night.
One more tip
When you are just learning how to trade options, a community of supportive fellow traders who can guide you and answer questions is worth its weight in gold.
Unlike some chat rooms, the Explosive Options chat room welcomes traders of all experience levels. Everyone is encouraged to ask questions, and no one is made to feel dumb. Have more questions about how to master trading psychology? What about finding trades in a bearish market? Chat room members will be happy to answer.
You can learn more about the chat room here.
