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Psychology and Trading

Unfortunately, new participants get punished with this naive mentality, shocked to discover that ‘winning’ trades aren’t enough to become successful in the forex market.

Trading is a head game and it’s not the market you need to beat … it’s yourself. Psychological habits built up over years or decades affect our trading decisions and stand in the way of long-term profitability. Psychology is the study of the mind, behavior, and behavior patterns. It’s what makes us do the things we do and how we overcome obstacles that are holding us back.


KEY POINTS

  • Discipline is the key to long-term market survival.
  • New traders need to write down trading rules and follow them.
  • Greed and fear control the buy and sell decisions of losing traders.
  • Most folks have trouble taking losses, which is a required skill for profitable trading.
  • Control emotions by limiting individual trade risk to a small percentage of total capital.

Trading Discipline: The Foundation to Profits

Trading discipline is the foundation to profits because it provides a set of rules to follow that lower the frequency of self-inflicted losses. We’re all human, prone to mistakes and miscalculations that no discipline can eradicate, but rules optimize this behavior so it doesn’t drive us insane. Even so, it won’t extinguish all greed and fear, the two strongest trading emotions and hardest ones to overcome.

Write down a set of trading rules to follow religiously to lower the impact of greed and fear. It’s harder to follow those rules than to put them on paper due to the destructive habits we’re trying to overcome. Rules can be as simple as trading just once per day or as complex and multi-leveled as entering a trade only when an instrument, for example, (1) bounces from support (2) after a bullish breakout, (3) confirmed by a bullish crossover in MACD and (4) rising RSI.

The forex market can evoke intense anger and frustration when it doesn’t do what you expect. Grudge trading, revenge trading, and trying to ‘get back at the market’ with wild bets are all deadly and real ways to lose your trading capital. Rules are intended to keep you from making trades based on blindness, triggered by these dark emotions, and the most important step you can take on the road to profitability.

List of Simple Rules

Here is a list of simple rules for speculative forex traders.

  • “I will risk no more than 2% of capital on a trade”. (Using a percentage instead of a fixed amount allows the trade size to grow or shrink, depending on account balance, in order to maximize profits and minimize losses).
  • “I will always trade with the trend. I will determine trends by price action, trendlines, moving averages, and momentum indicators”.
  • “I will only enter on confirmed long and short entry signals. My signals are bullish or bearish crossovers in relative strength and momentum indicators, confirmed by a breakout or breakdown of the 50-period moving average”.
  • “I will not enter if price action is within 3% of resistance for a buy trade or 3% of support for a sell (short) trade”.
  • “I will use support and resistance as exit targets. If the price reaches a target, I will exit to take profits”. (Some profits are better than no profits and infinitely more satisfying than losses).
  • “I won’t have more than one trade open on one asset at a time”.
  • “I won’t have more than five trades open at the same time, or risk more than 5% of account capital at one time”.
  • “I will always follow my rules”.

The last rule is the most important rule of all. It doesn’t make sense to have rules if you don’t follow them.

Negative Psychological Factors

The following list identifies the biggest reasons that traders lose money. These often-unconscious emotions generate bad decisions and must be addressed with specific rules to reduce negative fallout. When you take emotions out of the equation, better decisions, more consistent wins, and capital preservation will naturally follow.

  • Fear: one of the market’s most vicious emotions. Fear can keep you from making a good trade, or keep you from taking a timely profit. Fear of losing money will keep you awake at night but don’t let that stop you from trading. The solution: keep trade size small so one loss can’t hurt too badly and you still have the capital to trade.

Scared Trader

  • Greed: is as damaging as fear but the positive feelings make it harder to recognize. Greed is the other face of fear. Greed is the fear of losing profits you don’t have, or the desire to make big trades and take even bigger profits. Greed rears its ugly head when we’re doing well, taking most of us by surprise. In its most common form, profits build confidence beyond the current experience level, invoking greed that encourages over-aggressive trades and excessive leverage.

Greedy man

  • Ambition: a required trait for long-term success but a noose around the trader’s neck when it isn’t controlled.  Admittedly, it takes a ton of raw desire (and adrenaline) to succeed in the financial markets but ambition becomes dangerous to survival when it triggers bad decisions. Comparing results to another trader’s performance and letting that influence your decisions offers a perfect example of runaway ambition.
  • Loss: an inevitable part of trading that can be managed through rules and discipline. The goal is to take ‘appropriate’ losses while avoiding catastrophic career-ending losses. Position sizing is the key to loss management (2% rule), and not getting blinded by greed or fear and throwing away money. Walk away if you get frustrated from a string of losses.
  • Hope: turns against you when the ‘ticker tape’ turns against you. It makes sense to hope that your hard work pays off but the train goes off the tracks when ‘hoping’ a trade pays off the mortgage, buys a vacation, or saves a marriage. That’s ‘gambling’ not trading, a perfect way to lose your trading stake and wash out of the forex market.

Summary

Negative psychological traits and their impact on trade decisions need to be studied and mastered to succeed in the forex market. Putting it bluntly, emotions need to be removed from forex decision-making to be profitable in the long term. That requires specific rules, the discipline to follow them, and the ability to walk away when things go haywire.