FOREX TRADING PSYCHOLOGY
Forex trading is one of the most difficult professions to become successful. The number one reason new and experienced traders fail to make consistent profits within forex is because of the mindset they have when approaching trading. Forex trading is a 100% mental. Learning to control emotions and being disciplined is at the core of learning to become successful in not only forex but any profession.
Forex psychology is a vast topic, and many books have been published on the subject. This page will introduce the basic pitfalls all new and failing forex traders need to be aware of if they are to stand any chance of being consistently profitable in one of the most difficult and challenging professions in the world.
The fear of losing money and the fear of missing out (FOMO) is at the heart of forex trading psychology. Most if not all trading mistakes a trader will encounter and consistently repeat is as a result of fear.
Below is a list of damaging behaviours a trader who has not mastered the emotions of fear will undertake on a consistent basis when trading the Forex market.
Taking profits too early - fear of losing money
Traders who take profits before their intended profit target view their unrealised positive account balance and are fearful that they will lose the small gain they could potentially bank. The problem with taking profit too early is that it does not adhere to a fundamental trading truism - let your winners run! Banking small profits may feel instantly gratifying, but if a trader is risking £10 on a trade and consistently banking £2 or £3, they are setting themselves up to fail in the long run due to the effect of having an inverse risk reward ratio.
Not using a stop loss or cancelling the stop loss - fear of losing money
Traders should view losing trades as the cost of doing business. Trying to avoid losing trades by not using a stop loss or cancelling a stop loss as the market is going against a trade position is the quickest way to lose every penny in your trading account and more.
Barings Bank was a British merchant bank based in London, and the world's second oldest merchant bank, founded in 1762. The bank collapsed in 1995 resulting from an employee named Nick Leeson. Leeson's small traded losses spiralled out of control and his inability to accept losing trades compounded significantly. His fear of losing money is what ultimately brought the bank down after suffering losses of £827 million ($1.3 billion).
Hesitating to take a trade - fear of losing money
Hesitating to place a trade when the perfect opportunity presents itself is born from a fear of losing money. A trader who hesitates has feelings of doubt and is more concerned about the trade going against them than the trade going in their favour.
Watching your floating profit & loss - fear of losing money
Watching your account balance go from positive to negative to positive then back to negative and so on, comes from the fear of losing money. Once you have placed a trade and set the stop loss and profit target, there will only be two outcomes. Either your trade will win or lose. Watching your floating p&l will either lead to taking profits early or cancelling your stop loss. Watching your p&l leads to making decisions based on fear and not letting the trade play out.
Changing your trading strategy after consecutive losing trades - fear of losing money
traders that hop from one trading strategy to another after consecutive losing trades have a fear of losing money. What they don't understand is that losing trades and drawdown is an inevitable part of trading. This is why risk management, using a loss limit system per trade and understanding risk reward ratio is so important.
Adding to losing positions - fear of losing money
Traders that have cancelled their stop loss or don't use a stop loss are always in a very risky position. The only thing worse than not using a stop loss when in a losing position is adding to that losing position in the hope that the market will return in your favour. This is what is known as martingale trading. Martingale trading is the theory that you should double down on a losing bet in the hope that if you keep doubling down eventually, you will recover your loss. This is a recipe for disaster. If you find yourself in a hole, stop digging!
Chasing trades - fear of missing out
Seeing a missed trade opportunity after the market has moved in the intended direction will cause many traders to chase the trade. Rather than waiting for another trade, many traders will imagine what they could have made in profit and enter in the hope that the market will continue to move in their favour. The fear of not being able to capitalise on potentially the next big move is what drives traders to enter late and usually after the move is over.
Over trading - fear of missing out
The opportunities to place trades are endless. The forex market is open 24 hours a day 5 days a week. Access to the markets is also available at the press of a button on your phone or tablet. The need to trade because you feel you are missing out on making money will only lead to disaster.
Rest and relaxation is a major part of success in every endeavour. If you are trading during the middle of the night when you're supposed to be asleep or sneaking off to the bathroom to have a quiet moment to look at the charts while at dinner with family and friends, then you are over trading. Searching for trade setups on every time frame chart from the 1 minute to the monthly chart is a definite sign that you are over trading. The market will always present opportunities no matter what trading time frame you decide to trade.
A trader that identifies with any of the above behaviours needs to address their fear(s) immediately as it will have a detrimental effect on their ability to be consistently profitable. If a trader suffers from a combination of these behaviours, it won't be long until they become a part of the 90-90-90 statistic. A trader who takes profit too early and consistently cancels their stop loss will almost certainly blow up their trading account.
Solving the problems of fear is simple but not easy. The first step is becoming aware of the negative actions that the above actions can have on your trading. Having awareness in the moment and not giving in to the feeling of fear or greed is the foundation on which bad habits can be eliminated. Without self-awareness, traders will never be able or know how to change or improve.
Risk Reward Ratio
Risk reward ratio refers to the amount of profit a trader expects to gain on a position, relative to what they are risking in the event of a loss. Knowing this ratio can help traders manage risk by setting expectations for the outcome of a trade before entry.
A 1:1 risk reward ratio means that for every £1 risked on a trade, a £1 profit target is sought. A 1:2 risk reward ratio means that for every £1 risked on a trade, a £2 profit target is sought. A ratio where a trader is seeking to make the same amount or more than what they are risking is known as a positive risk reward ratio.
A risk reward ratio of 2:1 means that for every £1 risked, a profit target of 0.5p is sought. A ratio where a trader is seeking less profit than the amount they are risking is known as a negative or inverse ratio.
Below is a table which shows the risk reward ratios and the break even percentage.
A trader that seeks a 1:1 risk reward ratio will have to win 50% of their trades to break even over a series of 100 trades. This means that for a trader to make a profit using a 1:1 risk reward ratio will have to win 51% of their trades to stand a chance of turning a profit. A trader that seeks a 1:2 risk reward ratio will have to win 33% of their trades to breakeven over 100 trades and win 34% of their trades to make a profit.
Understanding risk reward ratio is important for a trader. Simple math proves that a trader can be wrong more than they are right and still be profitable as long as they profit more than they lose. If a trader endures ten losing trades in a row, they only need to win 5 in a row to return to break even if they seek a positive risk reward ratio of 1:2. If that same trader has a ten trade winning streak and then a ten trade losing streak they will still have a positive account balance!
'A plan without action is a dream. Action without a plan is a nightmare' - Japanese proverb.
The main idea of a trading plan is for traders to develop a set of rules or checklist criteria that they are going to adhere to and how they are going to implement those rules or criteria. The trade plan should stop traders making foolish mistakes (something that is especially beneficial when emotions start to come into play) and allow them to evaluate their wins and losses.
When developing trading rules, traders should consider the following:
When to trade (start time & finish time)
Number of currency pairs to trade
Maximum risk per trade
Maximum loss per day or week before trading is halted
Trade entry signals
Stop loss placement
Profit targets (reward/risk ratio)
Once traders have their rules written, it is much easier to trade with less emotion and mistakes as there is a clear plan of action.
Over a period of time, a journal will provide a historical perspective. Not only will it summarise all trades taken, but it will provide the state of a trader's trading account, showing each individual trade and the accumulated effects of all their trades to date.
A journal becomes a performance data base, which provides traders with the opportunity to go back in time and determine how often they traded, how successful each trade was, which currency pairs performed best and even what time frames gave the best profit percentages. Depending on how analytical a trader wants to be, they will be able to discover lots of information from journaling their trades.
One of the most useful features of a trade journal will be the detailed help it provides in forcing traders to change their habits from destructive to constructive because a journal provides traders with the feedback to develop and evolve their trading skills.
It is essential for traders to focus on the process of trading and not the outcome of a few trades results. By focusing on the process of trading, a traders mindset shifts from being concerned about the fear of losing trades in the short term to taking the correct trading actions. By taking the right actions consistently, traders will inevitably see positive improvements with their results in the medium to long term. Focusing on each trade outcome only sends traders on an emotional rollercoaster, especially during losing (and winning) streaks.
A successful forex trader is a person who is disciplined and follows their trade plan to the detail no matter what trading results they have in the short term. A successful trader aims for a positive risk reward ratio profit target on every trade and is aware of the effects of fear but does not succumb to the intense and divisive feelings and actions fear can invoke.