We’ll conclude the basic lessons of our school with a brief study of trading psychology and its effect on the profits or losses of forex traders.
It is rare to see a brilliant academic do very well in trading. While there are many scholars with degrees and honors from the most prestigious universities of the nation, there are not that many of them who have achieved exceptional success in trading forex. Suffice it to say at this point that the board of directors of LTCM included Myron Scholes and Robert C. Merton, two Nobel Prize winners, whose contributions to economic theory are among the most valuable in the past century. Nonetheless, even their analytical skills were not enough to save that firm from a spectacular collapse, as greed and euphoria overrode the dictates of reason, and leverage amplified the impact of false calculations.
It is clear that a lack of knowledge or expertise wasn’t the cause of LTCM’s demise. Instead, too much confidence, enthusiasm, a lax attitude to risk controls were the main culprits behind the firm’s demise, and it is possible to tie these factors to emotional faults with ease. To understand these emotional problems, and trader psychology, we’ll introduce you to the four forex demons in this text whose lies and deception ruin the careers of many beginners. The harm done by them is far greater than anything caused by faulty analysis or neglect of important information. While the results of one simple mistake can be readily corrected in time, the damage done by these beings is chronicle.
But let us remind you that the rewards of a successful battle with these troublesome beings can be unlimited. The trader who masters the psychological aspect of trading has walked two thirds of the way to riches, and all the rest is just a matter of patience and study, before the inevitable outcome of wealth and prosperity is attained.
The greed demon is the number one enemy of forex traders. This demon has a long and spiky tongue which constantly whispers to our ears that the opportunities in the market are going away unless we act quickly to profit from them. Its feet are on fire: it screams “faster, faster” to the trader, stressing him, causing him to lose focus. It has an empty belly, is emaciated, weak and hungry, because none of his exhortations for speed and greed lead to the slightest profit in the end.
It is perhaps natural that the vast majority of forex traders are money-oriented, profit seeking individuals who attach great importance to financial success. It is also true that without a strong drive for making money, no trader will be able to withstand the pressures of trading the forex market. In moderate amounts the drive to achieve monetary gain, and focus on financial success are healthy and necessary. But these healthy impulses become unhealthy when they direct our trading decisions: the greed demon needs to know his place, and he must not interfere in trading practices which must be formulated by logic alone.
How to avoid the wrong choices forced on us by greed? The first step for conquering greed is ensuring a disciplined approach to trading which minimizes the role of impulse in our trading decisions. By formulating a trading strategy in the beginning, and remaining loyal to this throughout the course of a trade, we can ensure that greed has nothing to do but bow down in silence as we study the markets and make our decisions based on reason and analysis alone.
Success can be achieved by a refined trading method, and its disciplined application. Emotions thrive where uncertainty and fear are rampant. To avoid such a situation, we’ll ensure that our responses to market developments are calculated and based on the principles established by our diligent study of them. Since our motivation alone, or desire for profits will not ensure that we actually acquire those profits, there’s nothing to be gained from listening to the teachings of the greed demon.
This fiend has a fearsome sight, and a sharp voice, bellowing, growling all the time, trying to intimidate us into indecision in everything that we do.
Fear has the opposite role of greed in our trading decisions. Instead of inspiring us to trade like a machine gun, opening and closing positions with the speed of lightning, fear convinces us that nothing that we do will be profitable in the long term, regardless of the power of our analysis, and the amount of study and consideration gone into perfecting our method. In this case, a fearful trader will be unable to wait for the realization of a profitable position, and he will be unwilling to act on the basis of rational expectations. In addition, the fearful trader will be unable to realize losses that result from mistaken assumptions, and the red ink in his account will keep spreading everywhere as a result. The result is usually ruin: as fear leads to more and more irrational decisions, and few trades are profitable, a few long-held losing trades will eventually wipe out the account.
It is necessary to distinguish between conservatism and fearfulness. Being conservative in our trading decisions is surely a healthy and sensible practice. A conservative trader is skeptical about everything he hears, but is still willing and able to act when his study confirms a profitable risk/reward prospect for a particular scenario. The fearful trader, on the other hand, is incredulous of not only the opinions of others, but everything that his analysis tells him too. He doesn’t know what to do, where to look, which trade to take and which to avoid, because all are the same to him. As he doesn’t trust his own logic, he has no tools with which he can understand or evaluate market developments. The end result is something akin to panicky gambling, with deleterious results being the inevitable outcome.
To avoid the disastrous effects of fear, we must train ourselves to understand that there’s nothing random about a successful trading career. We must be convinced that we are in control of our choices; we must have a clear plan to which we adhere with iron will, impervious to the illogical emotional extremes of the crowd. All that is only possible by a logical, calm approach to trading, which can only be gained by patient study. Another good way of avoiding fearful trading decisions is ensuring that we do not over leverage our account, and risking only so much that when the account is wiped out, we can laugh at the outcome, and go on and seek our fortunes in another aspect of life.
The queen of forex demons, Euphoria, is a creature that promises unlimited wealth, and delivers unlimited misery and destitution. Euphoria works hard to ensure that wherever we look, we see nothing but wonderful prospects for limitless profits. It is as if the trader has somehow been blessed with the Midas Touch, with success being the natural consequence of his routine behavior.
Under normal circumstances, euphoria has little relevance for most traders, because most are aware that success in forex trading is not child’s play. While magnificent profits in a short time are sometimes possible, such gains are usually the result of a period of study and practice during which the false promises of euphoria are proven repeatedly to be meaningless. In the case of the beginner, who doesn’t possess this background of hard work and study, euphoria may result from a string of profitable trades, as the trader comes gradually to believe that his understanding of the markets is impeccable, his analysis, flawless.
The key here is the knowledge that the first condition for performing a flawless analysis is beginning with the assumption that no analysis is flawless. Consequently, the successful analyst or trader is always skeptical about the value of his explanations, although he doesn’t hesitate to act on them because he bases his work on logic alone. The profit potential of the next trade taken is independent of how profitable the previous one was. Consequently, there’s no sense in getting excited about a string of profits: the next trade may or may not be profitable, depending on how diligent our study of the market was.
Thus, the best way of avoiding euphoria is by understanding that a string of wins or losses does not impact the outcome of the next trade that we will make. The success or failure of the next trade is only dependant on how capable we are of excluding emotions from our study of the markets, and in that knowledge lies the alpha and omega of a successful trading strategy.
Panic is the opposite of euphoria. In a panicky situation, the trader sees nothing but losses in the market, with no possibility of concluding a profitable trade. This is an exceptionally strange way of thinking in the forex market, since by definition; the loss of someone must be another person’s gain. When a trader is losing large sums on a long currency trade, another trader is possibly making large profits on a short trade on the same pair. This fact by itself should have helped traders to be more realistic in response to bouts of panic in the forex market, but experience shows that this is not the case.
So what are the causes of the panic that leads a forex trader to wrong choices? Obviously, periods of market volatility are the most common catalysts of a panic response. As price fluctuations increase in depth and frequency, the value of predictions diminishes greatly. This results in a loss of confidence in our trading choices, and if the period lasts long enough, the inevitable emotional outcome is panic in most cases.
A panicking trader will commit all kinds of errors. He will close a profitable position in expectation that it will reverse quickly, and will register losses soon. He will be unable to perform a logical analysis of his situation, and will instead become the victim of mental illusions on “potential” scenarios. The ultimate arbiter of a trade’s success or failure is of course the market, but for the panicky trader, all kinds of imaginary benchmarks, unreal expectations constitute the major criteria for the advisability, and ultimate profitability of a trade.
The impact of panic is greatly amplified by leverage, and the damage caused by it is intensified by tight stops.
To deal with the problems associated with trading psychology, we must minimize the role of emotions in our trade decisions. To minimize the role of emotions, we must understand that success or failure are not related to luck, but are the logical consequences of our own choices. We discussed before that it is almost impossible to have an unleveraged account wiped out as the consequence of a single trade. If the trader succeeds in realizing an empty account as a result of a string of losing trades, it’s hard to speak of luck or chance as being the causes of the disaster. Leverage is entirely in the control of the account owner; he can set it at any value provided that he can live with the consequences. Leverage amplifies the profit/loss potential of a trade, but it also intensifies the emotional aspect of trading too. Eventually, this intensification of emotional pressures may prove to be the most dangerous and negative impact of leverage.
The best way of dealing with emotional problems is acquiring a logical approach to trading. The best way of acquiring that attitude is understanding the market mechanisms, and the forces that direct economic activity. In this website, we have attempted to give you a basic understanding of those factors upon which you can build your own edifice of knowledge to improve your own potential for success in the forex market.
Next, part 9 >> Choosing the Right Forex Broker >>
Previous, part 7 << Forex Fundamental Analysis <<
Forex Lessons in this Forex Trading Course:
Lesson 1: How to read a currency quote
Lesson 4: Currency Pairs and Their Characteristics
Lesson 6: Forex Technical Analysis
Lesson 7: Forex Fundamental Analysis
Lesson 8: Forex Trading Psychology: The Four Demons of Trading Psychology
Lesson 9: Choosing the Right Forex Broker