Trading Psychology 101
This goes hand in hand with risk management as you need a solid mental state to stay disciplined in trading. The psychology of a trader determines their ability to manage certain conditions in the market, this may span from having a winning/losing streak to managing inactive trading times. Trading phycology describes the state of mind of a participating trader, as more often than not emotions such as fear, excitement, and greed can be detrimental to performance. Regardless of what your particular experience is in forex trading or how accurate your trading strategy may be, the need to trade with a certain mechanical discipline holds all the cards to your success as a forex trader.
This aims to explain a few theories that describe the relationship between trader psychology and market activities, including certain impacts psychology has on individual trading performance.
Prospect Theory
Prospect Theory by Kahneman and Tversky provides a method to understand business decision-making under risk. They suggest that individuals obtain more dissatisfaction from losing a specific amount in value than they get satisfaction when the exact amount of value is gained and this satisfaction from value gains or losses diminishes over time. In forex terms, this means we hurt more from losses than we rejoice from equivalent gains. This comes down to the biggest motivation being avoidance of pain, while the further effect on utility derived from continued gains or losses diminishes over time.
This explains the reason why some traders find it difficult to accept certain losses, causing the need to extend their stop-loss multiple times and in some cases take the stop-loss off completely. First, you avoid the pain by moving your stop once and then you accept the possibility of more losses by moving or eliminating your stop-loss completely.
A few more examples of the impact of psychology on forex trading will be discussed in the next section of this article.
Herd Mentality
This is simply the tendency to follow, copy or replicate the decision of a collective. As simple as this might sound, it explains why markets might remain in one direction while being overbought or sold for a significant period of time and why beginner traders are likely to buy at market tops and sell at market bottoms. This is because an aggressive move in one direction creates the belief that the direction will continue regardless of the market structure or sentiment.
Effects of Psychology
Discipline
The importance of discipline in retail trading can’t be overemphasized. This is especially important for strategy traders as success in this system of trading depends on adhering precisely to a set of rules within certain market conditions. Poor control of your state of mind as a trader would surely lead to a deviation from set mechanical rules, leading to negative performance
Assuming you have a series of losses, as suggested earlier by prospect theory, you are less likely to care about more losses, thereby increasing your propensity to adapt your rules to fit your current comfort level. More often than not this behavior would lead to a significant shift in your trading result.
Overtrading
This spans from the need for an activity or the lack thereof. Certain trading strategies may provide very few opportunities daily or monthly; this will give rise to a high amount of inactive times within sessions, days or weeks. The result of this is that you begin to feel unproductive and impatient for your next trade, eventually causing you to find opportunities outside your strategy rules.
Inactive periods can create emotional uncertainty; this is the fear or lack of confidence in your strategy altogether causing you to move from one strategy to another without giving each strategy adequate time to produce positive results.
Under Trading
This is mainly brought about by fear of taking losses; mostly right after a losing streak you begin to contend with the thought that continuing on your current path could lead to a blowout of your account. As a result of this fear you find yourself hesitating or outright avoiding perfectly good setups, causing you to miss opportunities that would then turn a profit. This leaves you subject to Murphy’s Law, which says “whatever could go wrong will go wrong,” causing you to feel like there is someone out there after your money as your strategy only seems to work when you’re not in a trade.
Another cause for under trading comes from a complete lack of confidence in your set strategy to begin with, so you tend to fill your mind up with ideas right before a setup completes, which then causes you to avoid the trade completely or go against your strategy’s entry and exit plan.
Mental Stamina
The truth, you will come to realize, is that trading is a boring sport. Depending on your strategy, you are likely to spend most of your time sitting on the sidelines hopefully waiting for a setup or preparing for one. It takes a great deal of mental stamina not to lose focus and grip on your routine, in which case you could end up in a wrong position or miss a trade altogether.
The lack of solid mental stamina can also course a trader to dump their strategy prematurely. This is one of the biggest problems in strategy trading as most beginner trader’s jump from one strategy to another without properly vetting each individual strategy. This is sometimes due to the inability to weather the storm each strategy might bring. As explained earlier, all strategies have their flaws; there is no perfect strategy, but there could be a perfect strategy for your personality. This means you can adapt to the flaws and take advantage of the strengths within the strategy.
Another major issue derived from the lack of mental stamina is the inability to follow through on what is actually required to learn this skill properly before either jumping into a live account or quitting the journey completely. You need an insane amount of patience and emotional intelligence to follow through at becoming a profitable trader. It is easy to learn the basic skills, but you need a lot of screen time and actual trading experience to fully understand the relationship your mental state has with the market. This is to the point where you have control over your reactions even when you might be swimming in losses.
Revenge Trading
This is a common psychological trigger that spans from frustration in the markets, either because of consecutive losses or from repeating a particular mistake over and over again. You revenge trade by forcing your will on the market, taking trades when you don’t have an ideal setup or compromising on your setups in general.
Let’s say your strategy needs three confirmations for a trade setup to be complete but because you have lost your last three consecutive trades, you jump into the next trade with only one confirmation, causing a complete skew of your actual strategy’s potential. If you are lucky, that trade will be a losing trade, which will force you into a state of reflection, but in a case where this wrong trade is profitable, you are likely to fall into a habit of switching up your trade plan for every other trade or completely changing up your strategy after every drawdown you encounter. This is likely to induce more frustration, leading to even more revenge trading.
Master Your Trading Psychology
Let’s take a dive into some solutions to the listed problems above. It is important to note that there are ways you can try to control some of the emotional outbursts you will likely have during your trading journey. These ideas are listed below:
Mentorship
Learning through mentorship is probably the best way any professional retail trader can advise anyone to begin this journey. Having a role model who is already successful at what you intend to get successful at is certainly the fastest way to achieving set goals, it also reduces or possibly eliminates the anxiety that comes with walking down an uncertain road. You can consider a mentor as a road map or guide to your desired destination as a trader; while you might not end up exactly as whichever mentor you begin with, you’re sure likely to carry lessons that will be exceedingly useful in shortening your learning curve through this process.
Having someone guide you makes it easy to have a reference point for your trades. This is possible in cases where you learn a strategy from your mentor; it is easy to verify whether you are right or wrong as you have a pre-existing framework to compare your actions against. This eliminates any confusion that could arise from fear or doubt of your set strategy.
The 100-Trade Challenge
We discussed a little about this idea earlier; as suggested, this is the challenge you undergo before you go live into the market for the first time. It requires you to achieve a backlog of 100 trades in your demo account that in total shows profitability and also the ability to have obeyed all your set rules from your strategy; this will display a snippet of how your preferred strategy is likely to behave over time. You are very likely to have experienced a drawdown or multiple drawdowns within this period, allowing you the ability to measure what you’re likely to expect during live trading.
So, if you begin to experience similar outcomes while trading live, you will be more equipped to deal with the stress of it all, thereby strengthening your psychological stamina in this market.
Trading Plan
We have mentioned a lot in this course about following rules, in order to do that you have to have rules written down in a clear and appropriate manner that aid your execution of the set plan. A good trading plan should cover how, why and when you enter and exit your trade. Having this all written out means you have a reference point with which to judge all trade executions.
Treat your trade plan like a bible; go through it a few times a day, before and after taking positions. Approaching your trading in this manner will certainly aid your discipline and give you the ability to track which aspect of your strategy may or may not fit your personality. A plan clarifies what exactly the process is to be, thereby simplifying the trading process. A good plan should also cover your daily trade routine, from how you start your research for current market conditions to how to begin to search for setups and then how you manage those setups.
Trading Journal
This can also be called the reflective toolbox as it is a record of all the trades you take and your reasoning behind the execution. This is a very important asset in your arsenal as a trader because only you truly know your strengths and weaknesses in trading over a series of trades. No single trade is a definition of/testament to the success of a trader or strategy, so you need a record of your results and process to make these conclusions over time.
Also knowing that you have to record a trade can force you not to go against your plan, and in some cases reviewing your trade journal can alleviate fear during losses as looking at past trades can give you confidence in the strategy or your abilities as a trader.
Only Risk Funds You Can Afford to Lose
All participants in the forex market are trying not to lose money or lose as little as possible to aid their profitability. The unfortunate truth is you can’t avoid losses completely; everyone loses a little or a lot sometimes. Therefore, it is only right that you use only money you can afford to lose to get into trading. Do not mortgage your house for a trading capital or trade with cash set aside for living expenses as these conditions are likely to heighten your emotions and cause you to make mistakes.
