Trading the forex markets takes hard work, discipline, a plan and the right personality to be profitable. You will be tested consistently and this will require a psychological mindset, which allows you to make the right decision when the going gets tough.
To become a successful trader, you need to keep your emotions in check, and have trader discipline. This will help you build confidence and allow you to execute your trading plan more effectively.
Having a Disciplined Trading Approach
The markets are made up of many participants who are at any moment experiencing a range of emotions which can generate volatile market conditions. Even the best traders fall prey to emotions such as fear and greed. There is a tendency amongst novice traders to place a trade when the market is experiencing high volatility and try to generate quick gains, based on gut feel, without a specific trading plan.
One of the best ways to promote discipline, as a trader, is to create a business plan. Generating income from trading activities is a business, and should be treated as such. You would never risk your hard-earned capital in a new car washing venture or restaurant, for example, without having a plan that shows that you can make money. It should be no different with your trading business.
Many traders realize that importance of having a checklist when making a trading decision to make sure they have all their ducks in a row, before they transact a trade. This is a great idea that will build confidence in your trading process and help you to analyze your trades better. It is very important that you have confidence in your process and approach, because if you don’t, you will pull the plug quickly when something goes wrong.
Trading Psychology Explained
It’s hard to completely understand trading psychology unless you have had direct investing experience. Most traders know that getting and staying in the right mindset is essential. This is especially true for the short term trader. If you are day trading the markets, you will need to make quick decisions on short notice, which can be the difference between a profitable or losing trade. At the same time, you need to be able to stick to a previously established plan where you are confident in booking profits and executing a stop loss. Your emotions need to be in check and they simply cannot get in the way of making time sensitive trading decisions.
Part of understanding forex trading psychology is to recognize the presence of fear and greed. While losing money is something you need to accept as part of the business of trading, it’s very hard to learn how to tolerate the uncomfortable feeling you will experience when you are losing money. You need to have emotional discipline as a trader, but it does take time to become relaxed and take losses in stride. If you want to become successful, it is important to know the effects of losing and winning on the psychology of a trader.
Understanding Fear in Trading
Losing money goes hand and hand with fear. Fear can overwhelm you if the position size is larger than normal, especially if you did not plan on taking a larger than normal loss. If you are a disciplined trader, and stick to your plan, when losses come around you will deal with them appropriately.
Experience will teach you to remain calm if you have a drawdown that falls in your range of expectations. If you have a strategy that wins 60% of the time, you should expect losses. You will never be happy when the market is moving against you, but if your strategy shows losses 40% of the time, you will become more comfortable with a loss as a potential outcome. What is much harder to handle is a situation where a trader takes unplanned risks which can adversely affect their investor psychology.
The Danger of Impulse Trades
Impulse trades happen much more often than you think. Most of the time a catalyst occurs where you make a snap decision and transact on impulse. When these trades move your way quickly, and generate gains, you can feel amazing, like free money has just fallen from the sky, but many times, these trades can move against you. You will then have a trade on your books, were you did consider the risks in advance.
There are several scenarios that can happen in the wake of an impulse trade. This haphazard style can generate fear, anger, and losses. Anger is generally the first emotion that you might feel as the market moves against you. You might be annoyed at yourself for placing a trade with such a cavalier attitude. If you are stubborn and do not want to take a loss, your anger could be replaced with fear. When you initially placed the trade all you thought about were the gains you would collect and now you are disappointed and fearful. Recognizing this type of negative trade psychology is the first step in overcoming it.
If you are losing more than you are accustom too, your trading mindset could be damaged and fear could turn to despondency. At worst, you become married to your trade. Becoming married to a trade is a term used to describe a trade where you decide that no matter what happens, you will ride the trade to profitability. This type of behavior often occurs when investors are trading a discretionary strategy.
The best way to handle an impulse trade is to make sure to keep the same risk management methodology you have within your regular strategy. So, if you normally stopped out of position with a 2% loss, then you should use this percentage to trigger an impulse trade stop loss as well.
There will be times in your trading career when you take on excessive risk and believe a situation will work out, but it does not. It’s important to understand that the markets can remain irrational longer than most people can remain solvent. This is a key component of trading psychology. You don’t want to perceive that you are bigger than the market, as the market has more resources than any one individual and can push you out of a position at any time. You do not want to fail to see the danger in holding on to a position that exceeds your risk limits generating losses that you never expected.
Fear, is a reaction where you perceive the threat of the loss of money. As we discussed, if you qualify your fear with risk management that is within your parameters, you will be able to make sound decisions, and will not be afraid of losing money. Most professional traders think of trading losses in terms of the cost of doing business. It is merely a business expense.
One technique you can use, if you are trading your own capital, is to pretend you are trading for a company where you have a boss who is evaluating your trades. If you must defend your trades to another individual, you may avoid placing trades that do not have merit.
Knowing there will be an ebb and flow to the equity in your trading account is part of the business of trading. There will always be pressures associated with trading, and consecutive losses can generate the fear that your strategy might be unsuccessful. Therefore, the more you know about your strategy or system, the better you will be able to stick with it during drawdown periods.
How to Handle a Losing Streak
A consecutive losing streak can test your discipline. Generally, when you begin to trade, you don’t think much about how many consecutive losses you are prepared to accept.
By avoiding this preparation, you are bound to create difficulties for yourself. Part of the risk management process is to try to think about situations that can throw off your strategy and how you will react during those times.
Thinking ahead of time about how a situation will play out will allow you to instinctively react to an event or catalyst. You can isolate and identify the feelings you experience during a trading session, and then try to focus on moving past any negative emotions that can hinder your progress.
If you have a strategy where you expect to win 70% of the time and lose 30% of the time, you should expect some degree of error. If you lose on your first 10 trades, you can assume that you need to go back to the drawing board to see if your strategy really works as intended. This is where demo accounts come in very handy. With a practice account, you trade theoretical capital. If you initially tested your strategy using a demo account but your success did not transfer to a real money account, you need to analyze why this is occurring. It’s quite possible that your emotions are interfering with your success in the live trading environment.
Demo accounts are prevalent across the forex spectrum. Nearly every reputable broker provides traders with demo accounts. Not only do these accounts allow you to test your strategy, but they also allow you to test your emotions, without losing capital. While you don’t experience the same emotions when trading a demo account relative to a real capital account, this technique can prepare you for different market situations.
For example, if you never experience the volatility surrounding a non-farm payroll release or a monetary policy change, it’s helpful to see how the market reacts without going through it for the first time with real capital.
Is Greed Good?
The movie Wall Street made Michael Douglass’s line “greed is good” famous, but as many experienced traders can attest, it can be a double edged sword. Greed can be helpful if it is contained and used in the context of your risk management plan. For example, if you are a trend following trader and your goal is catch a move by using a trend following strategy, you want to ride your trade, for as long as you can, until the market takes you out.
The chart above gives you a simplified example of when greed can be good and work out in our favor. If you entered your EUR/USD short position when the 20-day moving average crossed below the 50-day moving average, and your exit criteria is to exit when the 20-day moving average crosses back above the 50-day moving average, you don’t want to exit when the market initially moves your way.
Since you are trading a trend strategy, you will likely lose more times then you win, which means you must make much more money when you win, and stick to your plan allowing your strategy to be successful. This is when greed is helpful as you are trying to get as much as you can from the trend.
As long as you are trading within the context of your pre designed trading plan, being patient or greedy with your position can be beneficial to your bottom line.
Greed Can Be Your Enemy
There is another Wall Street adage that says “bulls make money, and bears make money but pigs get slaughtered.” Greed can be counter-productive when you only become concerned with the profit and dismiss your strategy or trade plan altogether in hopes of making that big win.
Usually this type of greed comes into play when the market moves your way beyond your planned take profit level and you decide that this is your home run trade and you abandon your strategy or rules.
This situation can play out in many ways. By far the worst is when you become so attached to the position that it eventually reverses and your gains become losses. You then become angry that you let this situation occur, and decide to hold on until the market moves your way. Your anger morphs into fear, as you begin to lose money, but you hold on to the trade and shrug aside your initial stop loss level leading to excessive losses.
You pray to GOD to save you and that if HE does, you will never let this happen again, so long as you can just get back to breakeven. But that day it seems that GOD may have been away from the office, as HE is not heeding your cry for help.
This type of negative greed can be difficult to overcome. There is something inside all of us that makes us want to scratch out every bit of profit from a trade. You need to be smart about your strategy, and avoid trying to extend unrealistic gains, especially when your profit target has already been reached.
The Importance of Discipline and Trading Rules
Trading rules are very important for every level of trader experience, but most important for the novice trader. Most novice traders are eventually knocked down and never figure out how to recover. By having specific rules in place, you can help yourself fight the emotional swings you will experience while trying to make money trading. Remember, you are not the only trader out there, there are countless people trying to make money trading the currency markets. While the game is not completely zero sum, as many people are using the currency markets to hedge exposure, nevertheless you need a solid edge and focused mind in order to compete successfully.
If you are the kind of trader that tends to get overly greedy, train yourself to put an order in the market that designates your take profit point. If you find that you get antsy as a currency pair approaches your mental stop loss level, put a hard stop in the market and let the market take you out. Be careful and make sure that your take profit and stop loss levels account for market noise, which will help you avoid getting stopped out by the normal market fluctuations.
If you’re a day trader, you can also set limits on your profit or loss for a day. If you make or lose a specific amount you can take a break or cease trading for the day.
You should periodically review and assess your performance along with the strategy that you are using to trade the markets. This goes beyond evaluating your returns to see if you are hitting your goals, it also means analyzing how you reacted to specific situations.
By analyzing what you did right and what you did wrong you can improve upon your performance. If you see specific mistakes you can correct them. Remember, what can be measured, can be improved.
The Bottom Line
Trading the capital markets requires a good trading strategy that you can execute efficiently. In addition, you need to be able to follow a disciplined trading plan, and avoid letting your emotions get in the away. You must understand that fear is a very powerful emotion. Most traders feel pain when they are losing money. This is a psychological crutch and needs to be addressed by each trader. When you come to grips with the concept that your reward is directly correlated to the risk you take in the market, you will understand that losing money is part of the trading process. It is the necessary cost of doing business.
Greed along with fear are the two emotions that dominate the trading landscape. When the markets move your way, it can become difficult to act prudently and stick to your trading strategy. Allowing greed to take over will eventually create a situation where you invite fear into the equation if the market turns against you.
You can help yourself in becoming more familiar with these emotions by reading trading psychology books, but its only when you are actually trading will you really appreciate its effect on you. Additionally, setting up trading rules, constructing a trading plan, installing a money management methodology, performing research and getting experience first with a demo account can help mitigate the negative emotions that can hamper your trading success.