The Importance of Psychology in Trading

Some general thoughts

When it comes to trading another aspect of utmost importance is purely psychological in its nature. Psychology refers to the way every trader perceives what is happening in the financial markets and how this perception can be influenced by emotions and ones susceptibility to different biases.

There exists a tendency the majority of participants in the market to experience a similar “set of thoughts and emotions”, while engaged in trading, but however, there is a certain difference between how those who are losing money think and how those who are making profits think.

Many traders strongly believe that a reliable and tested trading system is the only thing they need in order to perform successfully in the market. To outperform the market, in some cases, appears to be a not so hard task, but traders tend to concentrate a huge amount of their energy, effort and time in achieving it with the help of a particular strategy or a combination of strategies. Therefore, they tend to pay way less attention to how to overcome other barriers, psychological ones, such as emotional extremes. Almost always these extremes are the factors, which obstruct traders in making analysis and decisions of their own.

We should note something else. There is a reason why many individuals, who force themselves in the world of Forex trading, eventually experience severe losses. The reason for this lies in their expectations, which, in most cases, are quite unrealistic. Many people tend to believe that only a month or two of trading will enable them to leave their full-time jobs. Others tend to believe that a deposit of 1 000 US dollars may grow to the amount of 100 000 US dollars or more just in a matter of a few months.

Such far-from-reality expectations usually construct a completely incorrect mindset and fuel a pressing need to make profits, by all means necessary, in the Forex market. As the need grows larger, a trader unavoidably becomes controlled entirely by his/her emotions, a 100% percent sure way to go broke. It is this combination of wrongly defined trading objectives and unrealistic expectations, that, in most cases, leads to ruin.

Emotions in trading

Emotions are your worst enemy on the market and learning how to diminish their impact on your decision making is a rather tough task that can be achieved through years of experience. There are five common emotional mistakes that traders make and all of them have the potential to lead to massive losses, meaning you should do your best to overcome them. Those are the sensations of greed, fear, revenge, euphoria and pride. So lets turn our attention to each one of them.

Greed

Greed is probably your worst enemy and is just as hard to overcome as fear itself. Greed is a typical human trait, one on which the whole human society is based, of course to some extent. Each person has an instinctive desire to do something better, even the most lazy people, and to try to get a bit little more out of a certain situation. And although a small healthy amount of greed in life can be stimulating, there is no place for greed in trading, as even the desire to squeeze an extra 10 pips can be devastating, if an unexpected price reversal occurs on the way.

There is a very popular old saying among investors that “pigs get slaughtered” while bulls and bears make money. It means that the “greedy pigs” are bound to lose their money eventually, because they tend to hold to winning positions for an extended period of time in an attempt to milk each possible pip out of the market. And this doesnt come cheap, because it goes along with a huge risk of getting whipsawed by the market.

Another common mistake associated with greed is that people tend to add too much to a position, simply because the market has moved in their desired direction, instead of basing their decision making on sound analytical reasons. And it is not just that, it is very common for inexperienced traders to risk too much right from the start, instead of scaling in and using a proper money management system. Another frequently observed mistake derived from greed is that newbie traders choose high leverage right from the beginning, drawn by the possibilities of high returns. Well you can guess how that ends.

Euphoria

Euphoria is a variety of greed which arises after a trader has experienced a streak of winning trades or a single large winner. It builds an exceedingly positive sentiment and confidence, often luring you to enter and hold many new positions, usually in the same direction as the previous winner, which however can end badly.

This is the reason why some traders experience their biggest losses right after theyve had a good winning streak. It is very tempting to try and ride the winners wave immediately after youve earned some good profit, but you must keep your feet on the ground a draw a thick line between reality and the sensation that everything you do will turn to gold.

Fear

Fear is another overwhelming feeling, completely natural for each living creature, but unwelcome in a traders mindset. Fear can cause you to miss on profits by exiting a winning position earlier, miss on opportunities by not entering a position at all or induce losses when you exit a losing position too early and not give it a chance to turn profitable like your sound trading strategy had predicted.

Like animals, people feel fear as they encounter a source of threat, in our case the threat of losing money. Fear itself has a destructive power over your trading capital, but allowing it to get the best of you will then lead to further negative emotions such as anger, revenge and hatred. Overcoming fear requires a lot of practice, discipline and a lot of thinking beforehand.

Fear very often arises after a long series of losses and especially after having to swallow a loss larger than what you can emotionally absorb. By pondering before entering a trade and knowing how he instinctively reacts to stressful situations, a trader can learn to isolate the feeling of fear during the trading session and move past it.

As mentioned, a market player might be afraid to hold a position open due to fear of losing money. In many cases an unexperienced trader will exit a winning trade too early, due to fear of getting blown out by a price reversal. This is quite the opposite of greed and needs to be battled the same way – by relying on your solidly-tested trading strategy. This includes placing proper protective stops and price targets before you enter the position, ensuring that your trade plan will not be affected by newly arisen emotions during the trade.

The other two types of losses fear can incur – missing on opportunities by not entering a position at all or inducing losses when you exit a losing position too early, are based on the same principle and combated the same way – by trying to remain neutral and sticking to your previously determined strategy. One of the most efficient ways to overcome fear is to never risk an amount of money greater than what you are willing to lose on a cool head. If you have no problem with losing lets say 20 dollars and you risk only that amount, then you should, at least in general, remain calm during the session no matter what happens.

Revenge

As mentioned above, revenge very often follows fear and the negative results it carries with it. For example, a trader might get agitated on missing a very good entry opportunity after having thought about it but decided not to enter due to fear of losing money.

“Revenge trading” commonly occurs after a trader experiences a loss, especially if its greater than what he could usually handle. This once again calls out for using a proper money management system.

Many market players commonly enter revenge mode after a trade, which they were sure will be successful, goes wrong causing the loss of money. There are two things to be considered here: 1. there is nothing sure on the markets; 2. protective stops are your friend.

As they get agitated, inexperienced traders will try to make up for the scored losses by jumping straight back in the market. However, because the decisions they are about to make will be based on emotions, its very likely that they will fail and probably lead to a greater loss than the previous one. Revenge can be associated with overconfidence, which stems from pride.

Pride

Pride is another major issue some traders encounter. It reflects a behavior where traders refuse to admit and recognize their mistakes, thus rendering them unable to learn from them and improve. Basically the stubbornness of these traders drags them down and instead of getting better at what they are doing, they just worsen their performance.

Not acknowledging your mistakes and being overconfident in your capabilities leads to poor risk management, without which, as we know, you are doomed to eventually fail. That is why (its a pattern), you must at all costs remain neutral and stick to your predefined trading strategy.

Effective trading mindset is of critical importance

First, a trader needs to establish a plan for trading. This includes coming up with a plan how to amass knowledge of the area (Forex trading), attending trading seminars, taking up online courses and spending as much time as possible to do a research on the matter. One should take his/her time to study variations of price charts, read interviews with managers, policymakers, experts, or day-to-day analysis in specialized media and why not even do macroeconomic, corporate or industry analysis of his/her own. The more knowledge one obtains, the easier he/she could manage issues, such as fear.

Second, a trader needs to know his/her trading strategy to the last possible detail. He/she, just being acquainted with the strategy is not enough. Precision and complete awareness of what signals from the market to expect, in order to enter into a respective position, are obligatory.

Third, a trader needs to implement a strict management of risk. If one does not follow the strict rule to manage risk on each trade, the chance to give in to his/her emotions eventually increases. The best way to protect yourself against the chance of becoming a highly-emotional trader, is to risk only the amount, which you feel completely convenient to lose. This should be applied on each position one enters.

To expect a loss on any trade gives you the awareness that there is always a chance of such a scenario to develop, a chance of something unexpected to occur and adversely impact your position.

Fourth, an investor should abstain from over-trading. There is no need to trade way too much. One should simply know his/her trading edge (strategy) at one hundred percent and enter into trades, only in case he/she makes sure an opportunity is present.