Why is psychology such an important aspect in trading? Well, if you're incapable of controlling your mind/thoughts whilst operating in the market, you stand very little chance of reaching consistency.
Generally, traders, especially those new to the business, focus primarily on learning all they can about the technical side of trading. While we do agree that this is a necessary step for individuals wishing to function successfully by means of technical analysis, one MUST also place an equal amount of emphasis on mastering the psychological side of trading, as well. Unfortunately, the latter is often overlooked by so many!
During the course of this article, we aim to walk you through a number of different aspects relating to trading psychology, which we feel truly separates the winners from the losers.
Having a well-defined trading plan in place
Assuming that one has the discipline to FOLLOW their trading plan, it should help curb emotionally-driven mistakes. We personally think of a trading plan as a road map, guiding us through the market place. Without it, as far as we're concerned, you're essentially driving blind!
Below is a brief outline of what we believe should be covered in a trading plan:
- Risk parameters. This is where you will determine how much risk is to be allocated to each trade. Realistically, it should be an amount that you're comfortable losing without causing panic, which ultimately can result in 'revenge' trading. Revenge trading, for those who do not know, is the act of not observing risk management principles or executing trades beyond the scope of one's trading plan, in the hope of winning back a previous loss (or losses).
- Money management. Remember trading is a business, and should ALWAYS be treated as such. How one handles their account funds is crucial. This section should include, but is certainly not limited to, preparing for the worse-case scenario (how much of your account you're willing to lose before trading is to seize), planning for the long term and setting realistic financial goals.
- Timeframes. Filtering between different timeframes can be overwhelming for some and eventually lead to a poor trading decision. Therefore, it's imperative to have this outlined beforehand.
- Targets/Goals. Some traders set financial goals to achieve a certain amount per week/month and year. We try to remain somewhat flexible here by only having an annual percentage goal. The reason for this is that we firmly believe in being open to accepting whatever the market is willing to give us. Furthermore, if one has weekly or monthly targets that are not met, this can place a trader under pressure. And trading under pressure is not something we'd encourage!
- Markets. Will you stick to just the major currency pairs, delve into the minors or even the exotics? Do equities, commodities or bonds interest you? All of this should be well documented in your trading plan.
- Trading times. Though the market is a 24-hour auction house that operates five days a week, scheduling times to trade can instil some consistency to one's trading day.
- Performance evaluation. Evaluating each trade is crucial to the development of a trader. Remember, we learn by our mistakes!
- Software. Will you purchase specialized charting software or a dedicated news feed?
- Strategy rules. This is the section where one shapes his/her rules of engagement. Don't hold back here! Detail every point needed to confirm an acceptable setup. By doing this, you will avoid emotional decisions.
As you can see, without a trading plan you're likely going to be executing trades from a reactionary state. This is NOT a place you want to be. Compose a trading plan and refrain from trading blind!
Be careful who you follow!
Although there are a number of successful traders out there advertising trade setups for others to shadow, relying on these setups is not an approach that usually ends well for a number of reasons. For one, you have little knowledge of the method's nuances. Two, it's also impossible to know the psychological mindset of that particular trader from one day to the next. Above all else though, do you really want to spend your trading career relying on someone else's decisions? There is an exception to this, of course, and that is if you're using the trade calls to help solidify/complement your OWN trading setups.
Blindly trading other traders' ideas typically pushes one into a vicious psychological cycle. An illustration of such a cycle can be seen on the basic diagram below:
- At point one, you're full of optimism. The trader who provided the call to buy the EUR/USD (for example) has an outstanding record. So you naturally believe that this trade is highly likely to be a winner.
- The pair begins to move in favour and this carries you over into the excitement phase.
- At point three you're elated! The position has moved nearly double the position's risk and you feel on top of the world.
- It is at point four, though, where things begin to turn sour. Price starts consolidating and threatening bearish candles begin to emerge.
- At point five you've entered into a state of denial, as the market is now trading beyond your initial entry point.
- Taking into account that you have no plan in place to prepare for this situation, the next step is usually desperation. At this stage, you're essentially begging the market to get back to your entry level. However, even if price were to move in your favour and eventually lift itself back into the green again, would you, a trader with no plan for this, not just resort back to point one on the diagram above and begin the painful process all over again?
As we mentioned above, using other traders' ideas to complement your own setups is, in our opinion, a viable approach. Trading advertised setups blindly, however, will likely cause you a great deal of unnecessary stress.
Accept the risk
A financial loss is painful for just about anyone. That, we're sure, we can all agree on!
The majority of you reading this piece will genuinely believe that you already accept the risk on each trade you take. But do you really?
We're pretty sure that we've all been there. We place a trade and honestly believe that we are willing to lose the money invested i.e. have accepted the risk. Why then do we find ourselves altering the stop to protect our capital if the market does not act as expected? This, unless it is firmly in your plan to do so, is NOT accepting the risk. A way to overcome this is to begin trading positions that you are at ease with. What we mean by this is if you are feeling disappointed or angry at losing a certain amount of money, you may want to crank your size down considerably and work your way back up from there.
Accepting that your trades are random
What we want you to do now is visualize the perfect setup according to your rules. Now, picture the market steam rolling through your entry level like a knife through hot butter! This happens all the time and often leaves the trader in a state of confusion.
One has to realize that their analysis is NOT the market. The only reason the market responds to a setup is because other traders, often with deep pockets, get involved. Should others believe that the market is better sold at 1.2550 and you're selling at 1.2500, the trade will very likely fail.
Coming to realization that your trade outcomes are random is quite difficult for many. But until this happens, you will continue to have an emotional attachment to each trade you place.
Thinking in probabilities helps a great deal with this. In a nutshell, however, the point of this is to simply highlight and REMIND you that one losing trade means VERY little in the wide scheme of things and you can, even just by winning four times out of ten, still come out ahead. That is, of course, as long as you calculate risk accordingly! Taking colossal losses is a sure-fire way to a depleted account, and all the planning in the world will be of little use to you.
Having a can-do attitude
We believe this goes for just about everything in life! Without a positive attitude, you will likely get discouraged and emotional in this business. Still, we must point out that you mustn't confuse positive thinking with arrogance, as arrogance has absolutely no place in trading, despite what Hollywood films may portray.
Let's remember that the main goal of trading the markets is to make a PROFIT. Satisfying the desire to be correct instead of making money is NOT how professional traders operate. The realisation that you can be wrong several times and still accomplish your goals is a difficult concept to accept, but one that is an essential component to a healthy trading mindset.
Typically, we only have our thoughts to work with when trading. Having the discipline to control these thoughts will, in our humble opinion, make or break you as a trader.
Despite covering some important aspects in this article, we have barely scratched the surface. It's compelling to think of how much of an effect psychology actually has on us as traders, and how little it is covered in mainstream teachings. To that end, we hope to dive deeper into this subject in future articles…