Forex Trading Psychology

Why do 90% of forex traders lose money then? Well, the answer to that is poor risk management which leads to poor mind set and vice versa. Numerous books have been written about trading psychology and many consultants exist. Psychology is an extremely important point to focus on when trading.

Books on trading often talk about the mental problems encountered and Mark Douglas’ book Trading In The Zone. But the problem with some of these books is that they often tell you don’t think like this, or sit there and take losses during whipsaw periods. If a person was brought up thinking one thing it will be very difficult, even with coaching, to change the person’s inherent reactions. And on top of this, trading is extremely counter intuitive. It basically goes against what most people consider common sense. A phrase that a lot of trading experts use is “do the opposite”. A good analogy would be the advice given “when approached by a bear do not run.” It is the right thing to do and most people are taught to do it, however I can imagine there would be a very strong impulse to run if one has an encounter.

In the next section we will go through a common list of problems, describe how they occur, proceed and follow one another and then provide practical approaches that do not involve mind manipulation to avoid these problems. You should read books on this topic and seek counselling with experts about trader’s psychology. However, since it’s a long process to change your cognitive mindset we will discuss some practical ways to avoid the issues so you can trade meanwhile.

The Vicious CycleThe major part of this book instructs the readers on what to do. This section will talk about what not to do so that the reader can see the key psychological elements of trading and what patterns not to get caught on.The vicious cycle begins with a new trader studying the market for a bit, learning technical and fundamental analysis and getting excited about it since it does indeed work a lot of the time and in hindsight even looks easy. The trader may realize that all that is needed is an edge that will be right 51% of the time on trades that win and lose the same amount of money. That cannot be very hard he may think, some patterns out there are effective 60%-80% of the time. Finally the trader will see the edge that they like and begin to trade it live.Most of the time because of enthusiasm and an unbiased eye to the market the trader will have success in the beginning. Initial perception of the market is undistorted by negative emotions because there have been no losing trades. The trader will begin to experience a so-called state of euphoria and will feel like they are on top of the world, financial problems of the future are solved and they will start to act arrogant. The big mistake most will make is to start increasing position size. The attitude may be “I will not lose so I should increase my profits by taking bigger positions.” At some point the trader will take a devastating loss. There is no question about it because no pattern or edge works 100% of the time. The pain will be immense and now the trader is going to try to win back the money that was lost on the trade to get back to even so he can feel like the trade never happened. The primary motive for this usually will not be for profit but for peace of mind. He will not be as selective as before on finding the right trade and may enter on an even bigger position size to wipe out the loss. Now if the trader wins he will get even more confident and eventually lose on a second trade. After he loses big twice in a row he may consider making and even bigger trade to catch up. He will be so eager to wipe out the feeling of the negative trades and get his ego back that he will consider taking an even bigger position size. The trader will rationalize every wrong move made to make it right, justify his actions and never take responsibility for his losses. A classic example of this is poker players complaining about bad bets and others playing dumb. If surrounded by bad players a great poker player should adjust his style and take into account that the player will play bad cards, not cry about it after they lose. The losses and negative emotions will start piling on like a snow ball until the trader realizes that they have to stop. They will probably be down a substantial portion of the account, if not flat busted by this point. Now the trader will be more than humbled. He will feel like he can do no right in the market and will start saying that you can not make money trading or that his platform is rigged, someone manipulated his stop, the spread is too high and on and on. The trader may either walk away from trading all together or do an over extensive amount of education. Both approaches are bad since, even if he reads up a lot and comes back, the trader’s mindset will be drastically distorted by negative emotions.

Practical Ways to Deal with Negative EmotionsYou may have noticed that the above description contained many of the key negative emotions that come into play when trading. These include: Greed, Fear, Hope, Rationalization, and Cockiness. In this section we discuss how we can decrease these negative emotions during trading by taking practical steps.

GreedGreed occurs on many occasions during trading. Some examples and practical solutions include:1) When you are in a trade and you hold it for too long when you know you should exit.Solutions:i) Have set exit points that you back-tested your system with that you will follow.ii) Take partial profit on positions. Possibly place this in your systems rules.

2) When you start trading too big because of positive performancei) Determine the set maximum % of account that you will lose on any trade and do not exceed it under any circumstances.ii) Count the amount of losing trades that your system had when back-tested and understand that they may come in the future.

ConfidenceCockiness is the feeling of euphoria that you have after making numerous successful trades. This feeling can cause recklessness if not handled properly.1) You may start trading too big for your own good:i) Determine the set maximum % of account that you will lose on any trade and do not exceed it under any circumstances.ii) Count the amount of losing trades that your system had when back-tested and understand that they may come in the future.

2) You may make ineffective decisions because you have a feeling of not being able to lose:i) Have a checklist of everything that needs to be taken into account before entering a trade.ii) Have a checklist and a specific procedure of how your system needs to be followed, when it needs to be reevaluated, and exact entry and exit instructions.iii) Always increase the amount of work you do after you are successful.

Fear1) Fear may arise after you had a few unsuccessful trades and are now afraid to make a trade:i) Have a specific cutoff point before you start trading your system. Know the maximum drawdown you are willing to sustain and the maximum amount of losing trades you can handle prior to beginning to trade a system.ii) Don’t stop trading after a poor performance if your financial situation allows.iii) Start trading small to decrease the emotional level and concentrate on market and system analysis.iv) Create a profile of your trading psychology and determine what type of systems you will be trading. Can you handle a big drawdown? What type of profits are you looking for?

2) Fear may cause traders to get out of trades early and leave profit on the table.i) Have set exit points that you back-tested your system with that you will follow.ii) Take partial profit on positions. Possibly place this in your systems rules.iii) Don’t sit and watch every tick of the trade just follow your signals.

Hope and RationalizationHope and rationalization may cause traders to try to justify their decisions, blame others for their performance, and stay in trades that they should be out of because of hope that the market will move in their direction. This is a dangerous emotion and can turn trading into a gambling problem. It is very important to keep in mind that this emotion exists and make a good effort to control it.1) Hope and Rationalization may cause traders to enter trades that they should not be in because of hope that they will catch a break and make money.i) Control position size so that you are not trading to make or lose money but are trading to make the right decision.ii) Have set entry and exit points that you back-tested your system with that you will follow.iii) Take partial profit on positions. Possibly place this in your systems rules.

2) Hope and rationalization may cause traders to stay in trades longer than they should because of hope that the trade will go their way.i) Control position size so that you are not trading to make or lose money but are trading to make the right decision.ii) Have set exit points that you back-tested your system with that you will follow.iii) Take partial profit on positions. Possibly place this in your systems rules.