In this blog post, we’ll delve into the psychology of options trading, shedding light on the intricate mental processes that play a pivotal role in the options market.
Contents
Introduction
Psychology is an often overlooked factor when analyzing a trader’s performance, but it is vital in determining their long-term success in the markets.
Staying disciplined and focused on your trading is essential for making profitable trades in solid stocks.
There are many mental pitfalls to trading, such as confirmation bias, the illusion of control bias, loss aversion, and overconfidence, which can all impact a trader’s decision-making processes and lead to underperformance.
To help overcome these potential pitfalls, traders often have to be brutally honest with themselves and their trading.
Things like journaling your trades, reviewing your trade log, meditating, and having another trader look over your trades can all help shift you in the right direction.
At the end of the day, though, each trader will need to put in their own work to help keep them disciplined and focused.
Cognitive and Emotional Biases in Options Trading
Before diving into becoming a better mental trader, we first need to run through the pitfalls.
There are two main types of biases when it comes to trade: emotional and cognitive biases.
In their simplest form, cognitive biases are biases you try to convince yourself of with logic.
Emotional biases are slightly more primal; they usually tag into a fear or reward response deep in the brain.
First up, let’s jump into some of the more common cognitive biases:
- Confirmation Bias: The tendency to seek information supporting preexisting beliefs and ignore conflicting evidence.
- Illusion of Control Bias: The belief that one has more control over outcomes than is the case.
- Overconfidence Bias: The tendency to overestimate one’s abilities and underestimate risks.
Recognizing, understanding, and addressing these can help traders make more rational and objective decisions.
And it’s important to realize that these are never truly gone from your psychology.
The best traders in the world still slip up with these, but what separates them from the average is their ability to recognize, adjust, and fix the behavior seemingly on the fly.
Now that we have looked at the cognitive issues let’s look at the ones that hit your emotion centers and may be a little more difficult to pin down when analyzing yourself.
- Loss aversion bias: Traders often feel the pain of losses more intensely than the pleasure of gains. This bias can lead to holding on to losing positions for too long or taking profits too early, ultimately impacting overall trading performance.
- Overconfidence bias: Traders may overestimate their abilities and underestimate the risks involved. This bias can lead to excessive risk-taking and impulsive decision-making, resulting in significant losses. Think “YOLOing” into a trade.
- Self-control bias: Traders may struggle with maintaining discipline and adhering to their trading rules. This and overconfidence usually go hand in hand, thinking that “you know more than your setups.”
- Status quo bias: Traders may feel more comfortable sticking to familiar strategies and avoiding change. This is not saying to hop from strategy to strategy every 30 days, but it is the inability to adapt to market conditions because they’re new and different.
- Risk aversion bias: Traders may avoid taking risks out of fear of its outcome. This bias can lead to missed opportunities and hinder traders from maximizing their potential returns. This is the inability to execute even in the face of a solid trade.
General Solutions
Now that you know the mental barriers in trading, the rest of this article will be devoted to some ways to help fix them and improve your trading ability.
First, let’s take a look at some higher-level ways to set yourself up for success:
- Establish trading rules: This is also known as having a trade setup. By defining clear rules for entries and exits, traders can minimize emotional impulses and ensure that decisions are based on objective criteria. Ideally, you want to think like a programmer and try to make your trading setups as simple as possible.
- Implement risk management techniques: Proper risk management, such as stop-loss orders and position-sizing strategies, is essential. It can help traders limit potential losses and control emotions during changing market conditions. Another strategy here is to use daily or weekly max losses to keep your account from getting blown up.
- Create a supportive environment: Easier said than done, but with the internet, there are many places to look for groups and chatrooms to help keep you focused, disciplined, and learning.
Discipline in Options Trading
Discipline is one of the toughest things to implement in everyday life, especially in trading.
You are surrounded by a constant flowing stream of charts, tickers, ideas, setups, and people bragging about their best trades.
But their discipline separates someone from being a short-term success or a long-term trader.
What does discipline in options trading look like?
It’s having a plan and sticking to it.
If you trade primarily credit spreads, it’s ignoring Twitter saying that these 0 DTE calls are “sure to moon.”
Creating discipline in your options trading is much simpler than you think.
In addition to the broader steps above, there are a few ways to start.
The first is to narrow down your focus.
If you only sell cash-secured puts, try to keep only that in your scope of research.
The second is to focus on your tickers.
If you trade primarily tech, keep your watchlists and scans to the tech sector(s).
This list may seem overly simple, but limiting what you see to what you trade will make it easier to stick to your plan.
The third is to keep your flow of information limited to what will suit your needs.
Your mental capital in trading is just as important as your physical capital, so preserving that will help with your discipline.
The easiest way to do this is to avoid being on Twitter or any other news service during trading hours.
Most brokers have an integrated news panel, so if something huge breaks, you’ll know.
Finally, and perhaps most importantly, is to set a routine.
There are levels to this as well.
Personally, I have daily, weekly, and event drive routines that make it easy to stay disciplined and focused on my trading.
Weekly routines can include reviewing your trades for the week, looking through high-time frame charts for opportunities, and analyzing your position sizing and PnL goals.
These things should be done before the market opens to help keep you on track during the week.
Daily routines can include things like running your morning scans, looking through trading charts before the open, catching up on overnight events, and analyzing open positions.
Think of these as your trading-related plans.
Finally, some event-driven routines include journaling a trade after it has been placed and setting your profit and loss targets.
The goal of the routine is to make it almost automatic so that you don’t have to think about it; you just do it.
Focus
These things have been around discipline, but what about things to keep you focused during the trading day?
Thankfully, most of the actions that will help with your discipline will also help your focus.
A few additional things will help you keep focused during the day, but these are mostly lifestyle items.
You need to maintain proper sleep and eating schedules.
Making sure you are well-rested will go a long way in keeping you mentally focused during the day.
It will help prevent brain fog and keep your attention span operating at maximum capacity.
In addition, you need to keep yourself well-fueled with the highest quality ingredients you can afford.
High glucose diets often lead to the spike-and-crash feeling most people get throughout the day.
Eating so your body has constant energy will keep your mind engaged and strong throughout the day.
This invariably leads to better decision-making, stricter adherence to routines, and more emotional control.
These are all vital things to an active trader.
Conclusion
There you have it, a primer on focus and discipline in options trading.
Psychology is a highly individualized thing and, in the long run, can only be improved by self-reflection and personal work.
That said, the things we discussed above will go a very long way in setting you up for success.
We looked at many potential mental pitfalls in trading and several ways to help overcome them.
In addition to the general solutions offered, we looked at how routines will help to keep you disciplined with your trades and analysis.
If you stick to them, they will set you up for the best possible outcomes.
Proper rest and personal care will help keep you energized through the trading day and mentally strong.
Finally, focusing on nutrition will help keep your energy levels stable and your focus high so that you can look for the best possible trades throughout the day.
These are not a one-size-fits-all solution, but implementing even one of these techniques helps your trading in the long run.
We hope you enjoyed this article on the psychology of options trading.
If you have any questions, please send an email or leave a comment below.
Trade safe!
Disclaimer: The information above is for educational purposes only and should not be treated as investment advice. The strategy presented would not be suitable for investors who are not familiar with exchange traded options. Any readers interested in this strategy should do their own research and seek advice from a licensed financial adviser.
I use an option scanner website to avvoid getting emotional attached to a single company for too long