To succeed at any form of trading, whether that involves trading forex, stocks, bonds, commodities or derivatives, a successful trader needs to understand not only the algorithms and numbers involved but also the ever-enigmatic human factor.
The best traders must maintain an exceptionally steady nerve and avoid letting fear or greed carry them into poor decisions. This is even more so the case for the best prop trading firms, which do not make their money via commissions on trades with client money.
Instead, they trade on the market with their own capital, which boasts much greater rewards but a much bigger risk, and with this larger risk comes greater pressure to make every decision count.
That becomes far less about strategy and detailed trading plans and more about psychology, and with that in mind, here is a primer on the most important concepts and ideas behind psychology in the prop trading world, and how this knowledge can help firms get an edge in the market.
What Is Proprietary Trading?
Also known simply as prop trading, proprietary trading is any bank or financial firm that invests in the market directly, rather than making investments on behalf of other clients or organisations.
The practical elements of trading are identical in both cases, with the financial establishment making investments, but the sources of revenue and thus the incentives are significantly different.
With a company’s own money on the line, there is a lot more room for flexibility in the trading options and strategy that can be employed, but rather than a duty to clients to make the highest returns possible,
Compared to the often-thin profit margins that come from client-funded trading, prop trading provides a huge opportunity to make considerable amounts of money through speculative investment, with 100 per cent of the gains going to the institution.
They can also build up unexpected advantages and stockpile assets to help them during periods of illiquidity or when the market is down.
Some firms operate both client-focused and proprietary trading desks, but both pots of money are entirely separate from each other, to avoid a conflict of interest.
With risk and reward substantially higher, the psychological pressures involved similarly increase, and to explain how this affects trading behaviour we must look at behavioural finance.
What Is Behavioural Finance?
A subset of behavioural economics, behavioural finance is the study of how psychological biases and influential factors affect the decision-making behind major investors, financiers and financial institutions.
The primary focus of behavioural finance is that participants in financial markets are not perfect rational actors and will go into trading decisions with a series of biases and fundamental beliefs, each of which will affect their decision-making.
It also explores other aspects of mental well-being and physical health that affect their psychological state and by extension their decision-making skills.
Much like how a good or bad day will affect how people perceive any other situation, a rich tapestry of factors can affect financial decisions, and lead to market decisions that seem inherently irrational and undisciplined compared to an ideal, rational market actor.
There are countless examples of this, so here are some common psychological concepts that affect prop trading, why they happen and how you can take advantage of these common tendencies to improve your returns.
What Makes The Optimal Prop Trader?
Whilst there are many great traders out there with a wide range of skills and backgrounds, almost all of them have five particular psychological traits that give them an edge on the trading floor:
- The patience to avoid jumping into a trade at the wrong time or ejecting themselves from a trade at the first sign of trouble before a trend is established.
- The discipline to develop and stick to your defined trading plan and distinguish between signal and noise when it comes to the market and indeed your own emotions.
- The confidence to make critical decisions and the confidence to stand behind them because they were based on your strategic abilities.
- The ability to adapt to unpredictable markets and adapt your trading strategy dynamically when the time is right.
- The resilience to see the ultimate goal is not the impossible pursuit of a perfect record but to remain ahead of the curve in the long run.
Few traders will get far without demonstrating at least glimpses of all five of these characteristics, but traders are also human beings and as such will not always act entirely rationally.
Here are some examples of common psychological aspects that can cause the market to move in unexpected ways.
Herd Instincts
The concept of herd mentality is relatively well-known outside of the financial world. Humans are social creatures and so have a tendency to make decisions based effectively on popular consensus.
This is very commonly seen in investment circles, as many traders will invest in the same investments as other people, believing they can catch the market as it trends upwards.
There are countless examples of the consequences of herd mentality in finance, with perhaps the most notable being the dot-com bubble of the late 1990s.
Major investors, believing that technology companies and Internet-based services were the future, invested irrational and unsustainable amounts into start-ups and smaller companies, only to collapse just as quickly once it became clear that many technology stocks had been vastly overvalued.
Similar herd instincts have been blamed for the events that caused the 2008 global financial crisis, with the asset bubble being property and the mortgage-backed securities that had been extensively sold.
In the short term, herd instincts can be exceptionally useful for getting short-term gains, but do not get too ensnared by the mania, and be prepared to make an exit once it starts to become apparent that shares are overvalued.
Loss Aversion
One of the most infamous cognitive biases in the world of finance, loss aversion is the psychological concept that people are more emotionally affected by losses than an equivalent gain, and this can have a big and devastating effect on trading decisions.
This comes from the typical tendency for people to feel negative emotions more strongly than positive ones, which is why one negative piece of feedback can be more strongly felt than a pile of compliments.
More specific to trading, if someone has purchased a stock that is currently trending downwards and appears to be continuing in that direction, the rational decision is to realise that loss and move on.
However, investors are reluctant to accept that they made a bad decision, and thus will stick with a poor investment far longer than they should and irrespective of factors that they would consider if the trade was currently making gains.
The most infamous example of this was a stock trader who claimed to have an almost-bulletproof record of trading winning stocks, with over 96 “wins” and just one loss.
However, it would emerge that the reason why his record was so strong was simply that he sold any stocks that made a slight gain immediately and held onto losers, losing huge amounts of money in the process and eventually declaring bankruptcy partially as a result of this practice.
The Two Emotions That Control The Market
Whilst an oversimplification to some degree, there are two major emotional triggers that can make a greater impact on investment behaviour, both of which are bad for opposite reasons.
The first and most obvious of these is avarice or the greedy pursuit of more money. This is commonly seen in an asset bubble, where stocks are significantly overvalued but rationality is overtaken by greed and often leads to significant losses.
Conversely, fear is an exceptionally controlling emotion and just as harmful to a portfolio in the wrong circumstances. It can create cases where a slight fall in a stock’s value (which can happen on a second-by-second basis) can lead to an irrational decision to sell rather than determine if this is part of a wider trend.
There are other extreme emotions that control market decisions, such as anger and spite driving an investor to place irrational trades, and simply getting carried away by excitement is often also a factor, but fear and greed are often behind the most irrational market decisions.
The Fallacy Of Anchoring
As explored with the story of Lenny Dykstra, people tend to get fixated on wins and losses, and this often revolves around the concept of anchoring, or using the purchase price of an asset as a reference point for all future purchase decisions despite often being irrelevant.
For example, if someone bought a stock for £1000, that number does not, in theory, have any basis on the rationality of any future trading decisions. Selling for £1005 could be a monumentally bad decision, and selling for £800 could be inspired depending on future trends.
However, that initial £1000 figure will still factor into an investor’s decision making, and can lead to an undervalued asset being sold for less than it could possibly be worth, or that the stock was overvalued to begin with and getting as much as you can is still successful.
