During the fourth quarter of 2020, Bitcoin experienced a 171% surge. Ethereum, the second-largest cryptocurrency by market capitalization after Bitcoin, did even better in 2020, rising more than 600% (Bitcoin managed a mere 305% increase last year).
Few other activities will test your psychology like trading, particularly during volatile markets or when dealing with a difficult-to-predict digital asset class such as cryptocurrency. Emotions such as fear, greed, hope, anger and regret can negatively influence your decision-making process, causing you to act irrationally or impulsively. When driven by greed, for example, you might take unnecessary or inadvisable risks such as snap trades in pursuit of high rewards, while fear might cause you to become risk averse, resulting in trading hesitancy, missed opportunities, and (worst-case scenario) panic selling.
In order to manage the underlying mental and emotional challenges that we all face as traders, you first need to understand them, which is why trading psychology is so important. Only after you’ve recognized the unskilled trading behaviors that result from emotions rather than reason can you trade against the crowd with discipline—coolly, confidently and consistently.
Learning to look at trading differently
If you’re a seasoned veteran, chances are that you’ve encountered a few bumps along your trading road at some point already. It happens to everyone, even to the best of us. For those of you just starting out, your initial enthusiasm will likely serve as a catalyst or spark, igniting your trading career. However, don’t let that spark burn brightly and then die out just as quickly because of a lack of trading discipline. Emotions, after all, can be a double-edged sword.
Now before we think about how to stay the course through difficult times, let’s first take a look at the many ways in which psychology can sabotage our short- and long-term trading strategies and overall prospects.
- You cut winning trades short, despite thorough backtesting and a solid strategy.
- Fear of loss prevents you from making a good trade.
- A run of losing trades ruins your hope of breaking.
- You add to a losing position in the hope that the market will eventually rebound.
- You begin to trade aggressively after losing money.
- You veer from your trading strategy based on sudden market fluctuations.
- You stop trading or reduce your position size after a loss.
- You hold onto an asset longer than you should, hoping to hit the jackpot.
- Positive trading and big profits result in over-confidence.
- Failing to seize an opportunity due to poor past performance.
- Allowing media hype or negative chatter to disrupt your trading course.
As you can see, a lot can go wrong when we give in to our baser instincts. As Gary Dayton writes in his book Trading Mindfully: Achieve Your Optimum Trading Performance with Mindfulness and Cutting-Edge Psychology, “Cognitive biases and emotions can cause you to hold onto losers, take trades at the wrong time and in the wrong direction, jump into unplanned trades, and other erratic trading.” Crypto markets offer tremendous investment opportunities for traders, but there are a few things to keep in mind that will help you weather the storm when everyone around you is losing their heads amidst record-shattering rallies and heart attack-inducing plummets in value.
Market Downturns are Inevitable
Benjamin Franklin said that there are only two things in life that are certain. But Benjamin Franklin never traded cryptocurrencies. There are actually three—death, taxes and market downturns.
What goes up must come down. Things that rise also fall. However you say it, the basic truth remains: market downturns (and upturns) are unavoidable. The real question is not whether there will be a downturn, but how you will manage during one. Navigating through turbulent times is never an easy prospect, but there are a number of things that you can do to minimize the short-term pain while maximizing your long-term competitive edge, and understanding trading psychology is one of the most important.
Embrace your fear
Market downturns can be scary. Bullish markets or a negative period can cause markets to trend lower for weeks, months and even years. A volatile, high-risk digital asset such as cryptocurrency can spook traders, causing them to divert their trading to lower-risk investments rather than buying equities at market lows. Or, to put it another way, it can be difficult to grow when markets aren’t. But it’s not impossible.
“Keeping your head down, retreating from markets and turning introspective, while a natural human response to bad news, is a terrible option,” writes Stefan Stern in Managing in a Downturn. As Stern explains, “Now is not the time to...close yourself off to other outside influences. Keep an open mind to new initiatives, remain an active networker’ and, above all, don’t bury your head in the sand.
The importance of ambivalence
Our relationship to trading is one of ambivalence. It is the rare trader that always loves trading. On the other hand, no one would do it consistently if they always hated trading. One of the consequences of this ambivalence is that we are faced with balancing caution with optimism. During a downturn, however, determining how cautious or optimistic we should be can have significant implications for our trading portfolios, illustrating the problem of the emotional conflict involved when needing to resolve analyses and predictions about market sentiments during periods of fundamental uncertainty.
It’s no longer enough to merely mind the markets. In order to be successful and stay in the game, today’s traders must mind their emotions, a point David Tuckett drives home in his book Minding the Markets. An Emotional Finance View of Financial Instability. “The role of varying mental states and their impact on thinking processes,” he argues, “can systematically modify preferences, expected outcomes, and decision-making in a dynamic and path-dependent but nonlinear way.” Too often analysts ignore or overlook critical components of human psychology when evaluating market downturns. By embracing ambivalence and acknowledging the role of unconscious needs and fears when trading, you can better understand and manage your motivations and their consequences for your trading decisions.
A volatile market should be seen as an opportunity for long-term, strategic planning, allowing you to take advantage of high-return opportunities, guard against behavioral biases and benefit from better performance due to longer holding periods.
Gary Mishuris makes an interesting point about behavioral biases in an article for the Financial Times, observing that “Recency bias causes people to over-extrapolate the near-past further into the future more than the facts merit. Taking the long-term view on an investment should cause you to think about more than just what has been happening recently to arrive at a reasonable conclusion.” In other words, recency bias can lead you to believe that recent events or trends are more predictive of the future than they are likely to be. A cryptocurrency that has had poor trading results recently, for example, might be perceived by traders as having a higher likelihood of similar future results than if traders had examined the asset’s complete track record and long-term predictions by analysts and forecasters.
When volatility strikes, your instinctive reaction might be to hedge your bets and sell until the market improves. Downturns or volatility can be the worst of times, but they can also be the best of times, particularly for traders that want to create value for the long term, which brings us nicely to our next point.
Don’t Let Headlines Scare You
“Bitcoin Plunge Erases $100 Billion In 24 Hours–Here’s How Long The ‘Bloodbath’ Could Last” warns Forbes. CoinGape continues with the blood-letting metaphor: “Ethereum Price Analysis: ETH plunges toward 1,400 as crypto market generally bleeds.” Brett Arends piles on the hyperbole in his opinion piece for MarketWatch: “Stay away from Bitcoin and Ethereum—they are complete garbage.”
Are you scared yet?
Headlines are written to “tell and sell.” In the old days of print, a catchy headline sold papers. Today, a well-tuned article headline on a website can drive traffic and generate clicks. After all, how do you think I found these articles? A few keyword searches and voila—doomsday scenarios for cryptocurrencies such as Bitcoin and Ethereum.
First impressions are everything
But here’s the rub. Headlines can change the way that we think.
First impressions really do matter and content is no different. New Yorker staff writer Maria Konnikova makes the point in her article “How Headlines Change the Way We Think” seem almost obvious: “By now, everyone knows that a headline determines how many people will read a piece, particularly in this era of social media. But, more interesting, a headline changes the way people read an article and the way they remember it. The headline frames the rest of the experience. A headline can tell you what kind of article you’re about to read—news, opinion, research, LOLcats—and it sets the tone for what follows.”
Crucially, headlines can impact the way we think about a certain topic or product, informing our opinions and shaping our knowledge. Konnikova continues, “By drawing attention to certain details or facts, a headline can affect what existing knowledge is activated in your head. By its choice of phrasing, a headline can influence your mindset as you read so that you later recall details that coincide with what you were expecting.”
Kill that noise
While doing a Google search for this piece, another headline caught my eye. Writing for the financial news website Insider, Shalini Nagarajan’s article carries the following headline: “Bitcoin has been declared 'dead' 402 times since its inception. Here's how you can track the number of times it has 'died' in mainstream media.”
As Nagarajan reports, “Bitcoin’s ‘death’ can be tracked at Bitcoin Obituary, a parody website that collates news articles and blogs. It has already been declared dead nine times this year  and 14 times in 2020. But the highest number of ‘deaths’ it recorded (124) was in 2017, when its market cap hit $100 billion for the first time. The token’s most recent death was announced on February 24, 2021 by Steve Hanke, an American applied economist at Johns Hopkins University, who said it’s only a matter of time before Bitcoin ‘death spirals’ to its intrinsic value which is $0.”
Notice a pattern here? ‘Nuff said.
Diversify your portfolio
Diversify, diversify, diversify—it’s long been considered a cornerstone of a prudent trading strategy. Diversification is the practice of spreading out your investments in order to limit your exposure to any one particular type of asset. The rationale behind it is to help reduce the volatility of your portfolio over an extended period of time. Asset allocation entails diversifying across asset classes to help achieve your trading goals in a manner consistent with your time horizon, risk tolerance and liquidity needs. An effective asset allocation “smoothes the ride” through diversification, which helps reduce the overall impact of a drastic increase or decline in the value of one asset class.
But a word of caution. What I’m about to write might seem counterintuitive. Despite having a diversified portfolio, many traders suffered losses (sometimes significant ones) during the various downturns in recent years. Data suggests that the relationship between assets is much richer than what one might have first thought, as Jamie Alcock and Stephen Satchell argue in their provocative book, Asymmetric Dependence in Finance: Diversification, Correlation and Portfolio Management in Market Downturns, about asymmetric dependence and the challenges of mitigating risks in a bear market.
As they state, “Although tail risk has been a topic of research for the better part of the past 20 years, it took a global financial crisis for tail risk to become common parlance in the investment industry. In recent years, methods to hedge the tail risk associated with asymmetric dependence (AD) have become increasingly important to investors.” Although tail risks are by definition small and rare occurrences, they can and do happen and a diverse portfolio, while beneficial, cannot guarantee immunity from unexpected downturns.
Diversify, diversify, diversify. And then get up to speed on alternative portfolio performance management methods.
Beware of Overleveraging
Remember what I said above about headlines? Well, this one should scare you: “Overleveraged Crypto Traders Lost USD 2B In One Hour, Binance Leads Again.” Leveraged trading basically means borrowing money in the hope of making even more money and it’s risky business. A leveraged trader borrows funds to take a larger position than they’d otherwise be able to take with their existing funds. More risk translates into higher profits, or so the thinking goes. As the article makes clear, though, “while margin trading enables traders to amplify their returns, it can also lead to increased losses and liquidations, which is why experienced traders tend to advise newcomers to stay away from leveraged trading.”
With Bitcoin’s recent surges, some analysts are warning that the market is currently overleveraged, which will result in short-term volatility. However, as Bitpanda wrote recently, “Bitcoin has a tendency to sharply correct in a short period of time after a new weekly candle opens. This flushes out overleveraged longs and brings some balance into the market.”
Our advice: err on the side of caution and avoid overleveraging.
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