Forex trading psychology is a big thing. Often, it is the psychology, not a lack of academic knowledge or skill in application, that is considered to be the primary originator of trading mistakes.
Mistakes are constantly repeated by financial traders of various national, cultural and social backgrounds, which suggests that it is the common traits shared among us as humans that lie in the base of those mistakes.
That common trait is fear, which creates the fight or flight response in humans. Unfortunately, it is this fight or flight response which can cause the downfall of many traders.
We cannot change what we have evolved to feel over millions of years, but we can change how we approach these feelings by studying the psychology of successful Forex traders and applying the findings. Today, we will look at how we should behave and respond to trading situations from the correct Forex trading psychology point of view.
Fear can have a significantly limiting effect on trading behaviour. Naturally, your mind will want to find the safest option to ensure survival. In terms of trading, this means that if a trade looks like it is going to lose profit, your natural instinct would be to pull out of the trade so you don’t incur further losses.
However, this can take you away from a carefully planned trading strategy. Even worse, it could cause you to make rash decisions with the hope of turning that losing trade around, causing you to lose much more money than you would of if you had just left it to play out.
Instead of focusing on the long term plan, your mind wants to focus on making the best out of this short term losing position.
Understanding the role of psychology in Forex trading will help alleviate fear from your decision making process. Becoming aware of fear on the spot will empower you, both as a trader and as an individual. It will also allow you to re-establish the control of logic and reason, which is your ultimate goal.
Enemy mine
It’s easy for traders to feel confident in their ability to stay calm and collected during their trading sessions before the market opens. However, once the clock starts it’s a different story. When faced with real, financial decisions it’s very easy for emotions to come into play. We can’t avoid our emotions, but we can work around them. Traders cannot afford to give in to feelings of excitement, fear or greed when trading, as it can cause costly and irreversible mistakes.
Evaluate yourself psychologically by identifying if you are exposed to one of the following psychological biases of Forex trading:
Overconfidence bias – ‘The market will go here’
Anchoring bias – ‘This probably means that’
Confirmation bias – ‘This also proves that I am right’
Loss bias – ‘I hope the price will come back’
Notice how they overlap, because no matter how you look at it each of these biases boil down to fear. Nonetheless, we shall discuss them in detail because the first step is to become aware of our emotions.
Overconfidence bias
Lesson number one in Forex trading psychology is to watch out for trading euphoria. Humans are naturally self-focused. Our egos want to be validated through proving that we know what we are doing and that we are better than the average person. Any hint that confirms these thoughts only reinforces our self-image by a distinct feeling of self-love.
The problem is that this is where traders are most likely to succumb to the overconfidence bias. It’s not uncommon for traders to complete a winning streak and then believe that they can’t get anything wrong in the future. To believe this is of course unwise and is only going to end in failure. Make sure you always analyse your trading sessions and look at your wins and losses.
This is the only way you can really stay on top of your trading. Allow yourself to make mistakes – and don’t make the mistake of being scared to prove yourself wrong – you’ll be in a much better position for it in the long run.
You have to be comfortable with accepting that mistakes are inevitable, especially in the early stages, but it’s all part of the learning curve.
Anchoring bias
This one is about mental comfort zones created by traders when performing market analysis, ultimately thinking that the future will be the same as the present, purely based on the reason that the present appears to be like the past. Just as other biases in Forex trading psychology, this one is directly borrowed from social studies.
Anchoring is a tendency to rely on what is already known to a trader for decision making in the future, instead of considering new situations and the changes they can bring. At times, anchoring tends to cause traders to rely on obsolete and irrelevant information, which of course won’t help them trade successfully. In practical terms this manifests in traders holding losing positions open for too long, simply because they fail to consider the options that are outside their comfort zone.
You mustn’t be afraid of trying new things when trading Forex – be willing to try new strategies and go against what you know. By anchoring yourself to outdated strategies and knowledge, you’re only increasing the probability of bigger losses.
Confirmation bias
Confirmation bias is the one that is most common amongst traders. Looking for information that will support a decision you have made, even if it wasn’t the best decision, is a way to justify your actions and strategy. The problem is that by doing this, you’re not actually improving your methods and you’re just going to keep making the same mistakes. Unfortunately, this can create an infinite loop in Forex trading psychology that can be difficult to break.
The best case scenario in confirmation bias is that a trader will simply waste precious time researching what they already knew to be true. However, the worst case scenario is that not only will he lose time, but also money and the motivation to trade. A trader must learn to trust himself, and be happy to use his intelligence to develop profitable strategies and be able to follow them without fear or doubt.
Loss bias
Loss aversion bias derives from the prospect theory. Humans have a funny way of evaluating their gains and losses, along with comparing their perceived meanings against each other. For example, when considering our options before making a choice, we are more willing to give preference to a lower possible loss over a higher possible reward. Fear is a much more powerful motivator than greed. In practice, a trader with a loss bias is more akin to cutting profits when they are still low, while allowing bigger drawdowns.
Conclusion
There is only one piece of advice to solve the problems of traders that can be drawn from studying Forex trading psychology – develop a trading plan and stick to it.
As a trader in doubt, you should absolutely feel free to research every other possible remedy available, but the chances are that you will still come back to a simple trading plan. It’s understandable for traders to feel fear when trading.
However, being able to push this fear aside and work through it is absolutely vital for any trader who wants to be successful. Practice trading, make notes, research new strategies and make mistakes.
Trial and error is a massive part of the Forex learning curve, and generations of traders have proved that this is the most effective way to eliminate trading fears.
You might consider this example as a point of reference if you start to doubt yourself. Dr. Alexander Elder in one of his lectures told a story about an old friend of his, a private trader who was inconsistent and experienced periods of wins and losses alike. In a couple of years this trader’s name ended up on the US list of top money managers.
When Elder asked ‘How, what changed?’, the trader said, ‘I am using the same trading strategy that I always have. What changed is that I stopped trading against myself and my strategy.’ That money manager pulled a mental trick on himself.
When he was still a private trader and was inconsistently profitable, he pretended he was employed by an investment firm and had a real boss, who gave him a trading strategy and left for a year, leaving the man in charge with one condition. Upon the boss’s return, the performance of the trader will be not judged by how much money he made, but by how meticulously he followed the strategy.
In other words, he split his trading into two separate roles – the planner, who had no exposure to the market, and the executor, who had no say in planning.
What’s more, it worked.
