Trading Truths To Learn or Liquidate By #6: Psychological & Financial Capital

In this week’s instalment I want to address a topic I touched on in previous segments, this is the notion of Psychological capital and its value in the preservation and profit of financial capital. For many traders the focus is purely on their fiscal profit and loss and they fail to appreciate that this is only focusing on one store of capital resource and that a far greater resource lies within.Paying close attention to your psychological P&L can have a material impact on the glide path of your fiscal P&L.

Psychological Capital Defined

First of all lets address and define psychological capital, essentially psychological capital is your feelings and emotions. Traditionally traders have been instructed to act without giving attention to feelings or emotions to perform as if a robot. While the merits of removing impulsive behavior tied to negative emotions is certainly an optimal state to maintain, it is for most extremely challenging if not unobtainable.

The premise of developing your psychological capital is that a trader is better positioned to profit in the markets if they are more in touch with their feelings and emotions and learn to actually employ them in decision making and analysis. By becoming increasingly aware of our emotions and feelings when trading, we can actually enhance our risk management skills. The market is at is essence a representation of the collective feeling and emotions related to the price or value of a financial instrument, markets are at their core social exchanges. We are making trading decisions based on what we discern to be the future price another trader is likely prepared to pay for a financial instrument, this is less a mathematical type problem as it is a bet on a future feeling of value.

Feelings, Emotions & Risk

This notion of the inherent value of feelings and emotions is difficult for many traders to grasp, especially in markets predominately driven by testosterone, it is challenging for alpha male types to open up to their emotions and embrace and express their feelings. However, in successfully mastering this somewhat alien approach one can enhance their edge. The key to this challenge is accepting and recording emotional data, and using it as an input to our risk analysis, this unique style of analytics gives an extra dimension to our trading process and harnesses the natural feelings that are created when operating in circumstances where outcomes are ambiguous.

The principle objection to the idea of psychological capital, is that some believe that markets are less human-driven environments now as the emergence of high frequency trading and the proliferation of algorithmic programmes leads many to believe that their is no place for emotions in modern markets. What supporters of this notion fail to recognise is that the majority of these automated strategies are designed by humans and the design process is impacted by psychological responses and decisions, furthermore the ultimate decision to turn off a programme that is under performing, is a human decision and one that is often borne out of a heightened emotional response to adverse market conditions.

In point of fact the hypothetical scenario of managing a trading strategy when adverse market conditions are impairing performance is a good example of the value of managing your psychological capital to benefit of your fiscal capital. The challenge for traders facing adverse market conditions is that heightened emotions often propel impulsive negative behaviours. One of the principle benefits of recognizing and managing emotions is that we can identify the separateness of feeling from action.

Feeling And Action

The physical energy that runs through our body is generated from feelings, many of our actions are a result of fear, greed, anger, the edge that understanding psychological capital provides is the ability to identify these emotions and analyze their connectedness to your trading positions It is better to express these emotions either verbally or in written form as a way of diluting the energy they create and this process allows you to analyse their appropriateness to your trading process. More often than not these negative emotions are the catalyst for negative impulsive actions, by recording your emotional data you put in place a further filter of risk management, in this way your psychological risk awareness has an immediate impact on your fiscal capital.

Read the rest of the Trading Truths series here