Emotions in trading: a complete guide

Understanding how emotions can impact your trading decisions is one of the most important lessons a trader can learn.

Read on to find out how emotions such as fear and greed can affect your trading activities, and how to control these emotions, so you can make more reasoned decisions in the markets.

Emotions in trading

How do emotions affect trading?

Trading can be an emotionally-charged experience. It’s easy to become overwhelmed by feelings of excitement, fear and greed – any of which can have a negative impact on your decision-making. 

Here are some of the things that can be triggered if you base your trading decisions on emotions rather than objective market analysis.

• Cognitive biases: overconfidence and excessive risk-taking, or conversely, underconfidence and hesitancy, are just a handful of the cognitive biases that can be triggered by emotional trading.

• Impulsive decision-making: this can arise from a lack of discipline and oversight, leaving traders potentially exposed to greater losses. 

• Loss aversion: this can cause traders to become fixated on short-term losses and avoid trading altogether. 

Common emotions in trading

While the emotional spectrum of each trader is unique, there are 14 emotions most traders typically experience. These may come in cycles, from excitement and euphoria, to fear and panic, and then despondency and depression.

Let’s take a look at some of the key emotions in trading in more detail. 

• Euphoria: if feelings of intense excitement are triggered by a profitable trade or winning streak, this could distort your perception of the potential for significant gains. In this state, you could become more self-assured and fall prey to the overconfidence bias, taking more risk than you normally would.

• Fear: in trading, fear can be triggered by unexpected market volatility. It could cause you to base your decisions on anxious thoughts rather than sound analysis. This could lead to a panic-driven sell-off, where you close your positions early, or not open positions at all. 

• Despondency: this can be caused by a significant loss or series of losses. In this state, you may become fixated on failures and lose self-belief, become more prone to the loss-aversion bias, or give up trading altogether.  

How to control emotions in trading

There are no one-size-fits-all lessons on how to control emotions in trading, as every person is unique. However, there are steps you can take to better understand, and mitigate the negative effects that emotions in trading could have on your decisions in the markets.

• Practice mindfulness: practising mindfulness can help you cultivate an increased awareness of your thoughts and emotions. This could make you more likely to trade based on rational decisions as opposed to emotions.

• Try journaling: documenting your trading decisions, strategies, and emotional states could help you evaluate your performance, identify patterns, and rectify emotional biases going forwards.

• Engage in positive self-talk: consciously replacing negative thought patterns with constructive, affirming statements could help you boost your confidence, maintain composure, and minimise the impact of emotional biases in decision-making.

• Take breaks: it may sound simple, but remembering to take breaks could help you step back, recalibrate your focus, and gain some perspective on how your trades are unfolding amidst market events.

• Seek support: exchanging insights, discussing strategies, and sharing experiences with your fellow traders can help to bolster your emotional resilience.

The fear and greed index

What is the stock market fear and greed index?

Broadly, the fear and greed index operates on the premise that stocks tend to decline in response to fear and rise in value when influenced by greed.

The index was developed by CNN Business in 2012 to track the prevailing sentiment of the US stock market.

By assessing various aspects of stock market behaviour such as volatility, momentum, and safe-haven demand, the fear and greed index can give you valuable insights into investor sentiment and whether stocks are fairly priced at any one time.

How is the fear and greed index measured?

The stock market fear and greed index analyses seven distinct market indicators, each of which is standardised and assigned a value between 0 and 100. The average of these values is then calculated to determine the overall fear and greed index score.

• Stock price momentum: this indicator measures the performance of the S&P 500 (US 500) relative to its 125-day moving average.

• Stock price strength: to work this out, the number of stocks hitting 52-week highs and lows on the New York Stock Exchange (NYSE) is compared.

• Stock price breadth: this indicator involves analysis of the trading volume of advancing and declining stocks on the NYSE.

• Put and call options: the put/call ratio of option contracts is calculated, comparing the trading volume of bearish put options to bullish call options.

• Market volatility: the CBOE Volatility Index is used to assess market volatility and investor anxiety.

• Safe-haven demand: the performance of stocks versus bonds is evaluated, as investors typically seek bonds during the times of fear.

• Junk-bond demand: the spread between yields on investment-grade bonds and high-yield (junk) bonds is evaluated to access the junk-bond demand.

How to read the fear and greed index

The stock market fear and greed index operates on a scale from 0 to 100, with:

• 0 representing extreme fear

• 50 denoting a neutral sentiment

• 100 signifying extreme greed

Typically, extreme fear indicates that investors are pessimistic and may have oversold assets. Conversely, extreme greed suggests that the market might be overbought. 

As a contrarian indicator, if the fear and greed index shows extreme levels of fear or greed, this may signal that a potential reversal in the current market trend is approaching. Such levels could signal that the market is reaching an inflection point, and that there may be opportunities for a change in direction on the horizon. 

However, like other indicators, contrarian indicators are not fail-safe. Other factors should always be considered in your overall analysis of market conditions before you trade.

How does the fear and greed index impact trading decisions?

Traders can use the fear and greed index to gain an insight into market sentiment, which can in turn inform their decision-making. On top of this, the fear and greed index’s historical data can provide insights into how emotional extremes have influenced the markets in the past. In March 2020, for example, the index reflected extreme levels of fear, bottoming out as low as 8, as the world faced the COVID-19 pandemic.

Gaining insights into whether the market is driven by fear (suggesting potential buying opportunities), or by greed (signalling a possible overbought condition and the need for caution), can help traders understand market sentiment and better anticipate potential shifts in the direction of asset prices. 

The stock market fear and greed index can also help traders monitor their emotions and biases by providing an objective and external perspective on market sentiment. By monitoring the index, traders can gain insights into the overarching mindset of the investing community, and identify whether prevailing emotions are driven by fear or greed, and use this understanding as a counterbalance to their own psychological biases. 

For example, if the fear and greed index signals extreme greed, traders could become more cautious and avoid falling prey to the temptation of chasing overvalued assets. On the other hand, during periods of fear, the index can remind traders to remain level-headed and look for potential buying opportunities that may arise when markets are excessively pessimistic.

It's important to note, however, that the fear and greed index should not be the sole determinant for making decisions; rather, it may be used in conjunction with other technical and fundamental tools.

Factors influencing the fear and greed index

The stock market fear and greed index can be influenced by a range of factors, including:

• Stock market trends: various stock-market fluctuations can influence the fear and greed index, including price momentum, market breadth and volatility. For example, during a bull market, the index is likely to reflect higher levels of greed, while a bear market would tend to push the index towards fear. 

• Economic indicators: data points such as GDP growth, employment rates, inflation, and consumer confidence can help determine the overall health of the economy. In turn, positive readings can generally contribute to an optimistic market sentiment, driving the index towards greed. On the other hand, negative readings may lead to pessimism, promoting fear in the markets. 

• Global political climate: events such as elections, trade wars, and geopolitical tensions can bring uncertainty into the markets, affecting investor sentiment. During periods of stability, the index is more likely to reflect greed, while uncertainty can cause excessive fear. 

• Market sentiment: Positive news and strong financial reports tend to boost market sentiment and push the index towards greed, while negative news or disappointing results may cause fear among investors. 

Other factors that may influence the stock market fear and greed index can include anything from investor psychology and herd mentality to historical market patterns such as boom and bust cycles and seasonality. 

How to use the fear and greed index in trading

The way traders use the fear and greed index depends on their trading strategy. Here are some of the most common approaches.

To spot trends

Trend followers may use the fear and greed index to identify prevailing market trends. They could, for example: 

• Combine it with moving averages. One way to identify trends using the index is by comparing it with moving averages. A rising moving average can indicate a potential shift towards greed, while a falling one can signal a potential move to fear. By comparing the two indicators, traders can potentially confirm or disprove their assumptions about the prevailing market trend. 

• Spot sentiment shifts. Watching out for abrupt changes in the index can help traders identify shifts in market sentiment. A sudden spike in the index from extreme fear to extreme greed may indicate a market reversal, for example. On the other hand, a decline from greed to fear could signal a potential downturn or correction.

• Analyse divergence. Traders can compare the fear and greed index with stock market indices, such as the US 500 or the Germany 40 to reveal divergences. For instance, if the market is reaching new highs while the index is falling towards fear, it could suggest a lack of conviction in the rally and an impending reversal. 

To time entry and exit points

When the index shows extreme fear, it may signal that stock prices have become oversold and undervalued as investors sell off their holdings in panic. This could signal that a reversal from a bear to bull market is on the horizon. On the other hand, when the index shows extreme greed, it could mean that the market is overbought and a trend reversal from a bull to bear market is on the way.

Traders can use this information to determine their entry and exit points of opening and closing positions. It’s important to note, however, that the fear and greed index shouldn’t be used on its own, as it can create false signals. Traders may want to use other indicators to help them potentially confirm or disprove market signals.  

To assess risk appetite 

Traders can use the fear and greed index to evaluate the overall market risk. For example, when it indicates high levels of fear, it could suggest that market participants are risk-averse and pessimistic about the future, hence the sentiment is risk-off. In these scenarios, traders may consider a more conservative approach, focusing on risk management, and seeking out safe-haven assets or defensive sectors. 

On the other hand, high levels of greed could indicate a risk-on sentiment. This may signal that market players are overly optimistic and may be overlooking potential risks. In this situation, traders may want to consider caution and prepare for potential corrections or reversals.

Frequently asked questions