Crypto trading psychology: A deep dive
Whenever someone asks us why trading psychology is important, there is a very simple answer: because humans are not machines. Compared to machines we lack emotional discipline, make up with creativity though. Nevertheless, being emotional in trading is a disadvantage and we must become students of trading psychology to overcome that. As one of the best investors of all times said:
“You don’t want to be a no-emotion person all of your life, but you definitely want to be a no-emotion person when making an investment or business decision.”
It’s the difference between growing as a trader or ending up burnt. Emotion and psychology are significant pitfalls, leading to holding onto losing positions and refusing to exit winning ones. We’ve all been there, watching that price tick upward and thinking it will go on forever. But experience is the best guide. That is why our article goes to discuss three main things in trading psychology: be aware of oneself, be aware of others, and always do risk management.
So, how to be aware of oneself? It is likely that if you are investing in crypto, your risk profile is higher than usual. Even studies argue: “it would appear that most individuals who engage in day trading are heavily involved traditional gamblers who include day trading in their repertoire of activities” according to Arthur & Delfabbro (2017). This was also underpinned by a UK residents’ survey, where almost a third admitted their crypto purchase was more of a bet than a business (FCA, 2019).
You just have to be aware that the crypto market has always been known for volatility and unpredictability. Some might even argue that crypto needs much more risk management due to the high volatility. These people are probably right. Wild price swings create both opportunities and challenges for investors.
One of the most important things is to stay calm and avoid FOMO trading. Meaning, just because you heard something somewhere, you should not just invest because you are afraid to miss out on big returns.
A great example is the case of Three Arrows Capital. It sort of serves as a cautionary tale, where excessive leverage led to significant losses during a period of heightened market FOMO.
The 2021 frenzy led to many blow ups, even of huge crypto funds that seemed invincible and all-knowing at that time.
Do yourself a favour, listen to trends, but always do your own research. You can sometimes ride the bull wave, but choose your battles wisely. Know when it’s a real opportunity and when you are a victim of FOMO – your portfolio will thank you.
Now, you know to be aware of your own pitfalls, you should know that most people and traders out there are not. Those are often called the fish, who are ripped of by professional investors. Rising prices attract greater interest from new investing participants with emotions trending positive. Indeed, markups are typically influenced by new traders’ FOMO (Fear Of Missing Out) and greed. Traders use the Fear & Greed Index to gauge these types of emotions.
For example, the Fear & Greed Index gauges the general crypto market sentiment at a specific moment in time and is represented by a number that ranges from 1 to 100. A “1” represents extreme market fear (investors are selling) and a “100” represents extreme market greed (investors are buying).
Fear & Greed Index (source: alternative.me)
When the index value is near the “Fear” level, this represents a buying opportunity. There is a certain “Fear” in the marketplace, meaning that investors are afraid of buying at this time. Therefore, the price might be lower as investors sell over fears that crypto is going to lose value.
On the other hand, if the index value is near the higher “Greed” level, this would generally be interpreted as a selling opportunity.
“Greed” or positive market sentiment peaks during the markup phase, with many traders being optimistic about the future. Consequently, prices frequently hit all-time highs (ATHs) during this phase.
Finally, indications like this actually make you understand the other traders better and take advantage. Once you know the market sentiment, you can actually position yourself accordingly and profit from the emotions of others. The important thing here is not to get overly confident though. In fact, that is where risk management comes in, our third pillar of trading psychology. As Benjamin Graham once said:
“The best way to measure your investing success is not by whether you’re beating the market but by whether you’ve put in place a financial plan and a behavioral discipline that are likely to get you where you want to go.”
For that reason, even if you know your own psychological disposition and can even put a figure on other traders’ emotional state, you have to practice risk management. It is crucial, as you might always be wrong in some situations and you should protect your portfolio by position sizing and having take profit orders and stop-loss orders.
Position sizing:
- Decide the most you’re okay with losing, like 2% of what you have.
- Figure out that amount in dollars.
- Check the difference between your buy price and stop-loss.
- Divide the dollar amount from step 2 by the price difference from step 3. This tells you how much to buy.
- Change this amount depending on the market and how much you’re okay with risking.
Take profit orders:
- Decide the profit you want, like 20%.
- Calculate the price for that profit. If you bought at $1,000, 20% profit means selling at $1,200.
- Set a “take-profit” order at $1,200.
- If the price hits $1,200, it sells automatically, and you make a profit.
Stop-loss orders:
- Determine the maximum loss you’re willing to bear, for instance, 10%.
- Calculate the selling price that represents this loss. If you bought at $1,000, a 10% loss would mean selling at $900.
- Set a “stop-loss” order at $900.
- If the price drops to $900, the asset is sold automatically, preventing further losses.
Hint: For those who like to use profitable candlestick patterns, you can always use the level below or above the pattern as your stop-loss level.
As you saw from this article, the world of crypto trading is not just about charts and numbers; it’s deeply interwoven with human psychology. Emotions, when unchecked, can lead to catastrophic decisions, causing massive losses. By understanding oneself and the market sentiment, a trader stands a better chance against pitfalls. Position sizing, take profit orders, and stop-loss orders are the trinity of risk management that help in maintaining trading discipline. Obviously, no one knows the magic formula, but from what successful traders say – the key to successful trading is a blend of self-awareness, understanding market psychology, and adhering to a structured risk management strategy. Let logic and strategy be your compass, not emotion.
