The psychological effects of forex trading

 

A popular saying suggests that 90% of trading forex is in the mind, with the remaining 10% being the trading system or strategy employed. It is essential that all traders understand the psychological effects of trading in order to develop ways to mitigate the negative effects of letting emotions affect our trading decisions. The combination of fear and greed are both the enemy of a successful trader and being able to keep these balanced whilst opening and closing trades is one of the single most important aspects of becoming profitable. There are a number of ways in which traders try to keep a check on the psychological aspects to trading and very much depends on the type of trading personality of each individual trader.

Using a mechanical trading systems

One of the reasons why automated and mechanical forex trading systems have become so popular is due to the fact that they remove the emotional decisions of a trader. Traders often prefer to use a rigid set of rules for both entry and exits, planned in advance of the trade, in order to ensure that they don’t get emotionally caught-up in the live markets. Trading systems, whether automated or mechanical, remove the impulsive reactions of traders which can lead to bad investment decisions such as closing positions too early or hanging on to a position too long.

Although many automated trading systems, known as Expert Advisors (EA’s) are highly unreliable, this shouldn’t prevent traders from developing a mechanical way to trade their own personal strategy. Mechanical trading is a fixed set of conditions or rule which, once achieved, provides a buy or sell signal with limited emotional decision-making from the trader.

Applying stop losses to every trade

Entering a forex trade is often described as far easier than exiting due to the fact that closing a position will often result in either a profit or a loss. Two fundamental mistakes that traders often make, however, is either keeping a position open too long, risking profits or extending losses, or not allowing a trade enough time to develop for fear of making a loss.

Stop losses are an excellent and essential way to insure that each trade is executed as planned and removes the emotional decision from the trader. Without a fixed or floating stop-loss, planed in advance of entering the trade, the temptation can be to let losses accumulate when the trader’s perspective of a failed trade becomes blurred with self-confidence that the trade will eventually work out. Stop losses act as a mechanical way to close out losing positions and also allows traders to project accurate win:loss ratios and develop a solid trading system.

Removing emotions from trading decisions is one of the most important aspects of becoming profitable and something which many new traders fail to take in to account. The psychological effects of live markets with real money will effect each trader differently and for this reason developing strategies to remove decision-making during a trade becomes absolutely essential.

Trading using recent highs and lows

Every price action trader will know the significance of being aware of recent price highs and lows. Whether this is the previous daily high and low of a currency pair, or a swing high and low following a trending move on a price chart. The importance of being aware of these levels is that they offer traders a good insight in to where short-term areas of support and resistance may exist. These areas can then be used both to look for high-probability trade set-ups and to avoid trading in to a congested area of limit orders.

Using the daily high and low to trade

The previous daily high and low mark the extremes that price reached during that day and show forex traders where the market considered the bottom and top of trading for that day. This is important not only as a psychological level for the next day but they are also used in the calculation of daily pivot points. These pivot points provide traders with a daily map of areas of potential support and resistance and for many price action traders they identify the zones where the market is likely to reverse.

The previous daily high and low can also be used by traders as reliable levels of support and resistance in their own right. Looking at any intra-day price chart it is clear that once price breaks through this previous level, it very often converts in to a reliable area of support or resistance. These are made even more significant when they occur near to round numbers of psychologically-important areas.

Using Fibonacci with recent highs and lows

One of the things that all forex charts have in common is that they contain short-term trends. This can be seen across all timeframes as price moves higher and lower to create either upward or downward trends in price. These trends, however, do not last forever and they reach a high or low before retracing. Forex traders can take advantage of these ‘retracements’ by applying Fibonacci levels to the swing high and swing low of any visible trend. These then provide a highly reliable set of support and resistance levels based on the perceived ‘natural’ order that markets follow. This occurs through the application of the Fibonacci ratio to the distance between the trends swing high and low.

Whether Fibonacci ratios actually exist naturally in forex markets is open to debate, however, these level are highly significant because a very large number of traders use these to place their orders. It is therefore very common for price to stall and reverse during a retracement at these Fibonacci levels. Of these, those which can be considered the most effective are the 23.6, 38.2 and 61.8 percentage retracement levels of the recent swing high and low points of a trend. Whilst these levels should not be used as trading signals on their own, they can act as an excellent complement to both price action and technical traders looking for confirmation of an area of significant support or resistance.

Technical v Fundamental forex trading

Most forex traders will already have an idea about whether they consider themselves a fundamental or technical trader, based on the way in which they make their trading decisions. For technical traders, trading setups are completely chart-based, with recurring patterns and high-probability indicators allowing setups to be traded mechanically. For fundamental traders, the majority of their trading decisions will be based on the longer term, underlying forex trends which push currency markets higher or lower over a period of time. Other traders may utilise a combination of both technical and fundamental information to decide on which trades they prefer to take. Whilst neither way is better than the other, it is beneficial to know which way you prefer to trade in order to develop your trading ‘personality’.

Technical forex trading

For technical traders, charting is an essential element when looking for profitable opportunities on both short-term and long term timeframes. For day traders especially, looking for short term price patterns on the higher timeframes can allow them to see the underlying direction for trading on the shorter timeframes, which is why many will choose to flick between these in order to find the most highly profitable trading opportunities.
Technical trading can include recognising popular trading patterns which show traders what is likely to occur in the near future. Whilst technical trading is not a perfect crystal ball and is not a guarantee of the future direction of price, it does offer a strong reason to take a trade based on two assumptions. The first assumption of technical traders is that the trading pattern (double top, head and shoulders, wedge etc.) develops over a period of time and is a visible demonstration of strength or weakness in the market. The second is that, because there is a whole load of other traders seeing exactly the same pattern and expecting the market to react in a similar way, it becomes self-fulfilling and this increases the likelihood of the price movement occurring.

Fundamental forex trading

Fundamental traders, on the other hand, are not so focused on visual patterns but look to data and news events to drive prices higher or lower. Key economic indicators (GDP levels, employment data and interest rates etc.) are monitored by fundamental traders who then buy or sell currencies based on this information. These key indicators are the underlying drivers of the markets and provide the real-world rationale for forex pairs to move higher or lower. Although fundamental information, such as big news events, can be very successfully traded on an intraday basis, many fundamental traders look to hold their positions for longer periods of time. This essentially allows traders to use the trend as their friend; trading with the underlying factors which push currencies higher and lower.

Combining technical and fundamental forex trading

Although neither technical nor fundamental trading can be considered the only ‘correct’ way to trade, the preference of either will demonstrate different types of forex trader. These trading techniques do not have to exist separately either, with many traders combining fundamental and technical elements in to their analysis to try to ensure that they have as many things on their side as possible before taking a trade.

Money management and forex success

Many have said that it is not necessarily the trading strategy that you employ but the psychological aspects of trading forex which will determine a traders’ success. Whilst this is certainly true in terms of being disciplined to stick to the rules of a trading system, there is also another essential element to becoming a profitable forex trader. This can be described as money management and the ability to protect trading capital and to ensure that a trading account moves in the right direction over the long term.

Three golden rules of money management in forex trading

Money management includes two or three golden rules which, if maintained, will substantially increase the possibility of becoming a consistently profitable trader regardless of the trading system used. Although it is useful to have a perfect trading strategy, the truth is that all traders will experience losses and losing trades regardless of how good their trading system may appear. It is how these losses, and expose to loss, is controlled which will determine if a trading account is still in operation a few months later. Since many traders may find it difficult to admit loss, it is essential to automate rules to deal with losses as much as possible.

The first way to limit losses is to physically limit the risk on each and every trade. This should ideally not be any more than 2% of the total trading capital available within an account. Despite this seeming like a very small amount to be risking on each trade, the reason why professional traders follow this rule is to allow them to absorb consecutive losses should they occur. For small forex accounts, it is tempting to risk anything between 20-50% on each position but this can easily deplete an account if a trading strategy fails to perform for more than one trade.

A second measure of good money management is the risk-to-reward ratio that is applied to each trade. Ideally, trading with a risk-to-reward ratio of 1:2 will allow a strategy to lose a number of times but still remain profitable over time. This means that the amount of money being risked, or the potential losses, are lower than the potential gain from a successful trade. With a strong ratio, the number of winners will not need to be higher than losers for long term profits to be realized.

Stop losses as tools to reduce trading losses

Finally, given the difficulties that almost all traders initially have in accepting losses, it is important to ensure that bad trades are closed as quickly as possible. One of the most effective ways to do this is to employ an automated stop-loss which is placed in the market when a forex trade is placed. Stop-losses act a safety nets against large market moves and limit the loss on any losing trade to a pre-determined amount. Although stop losses do not guarantee to close a position at the precise price in fast moving markets, they will avoid the temptation to “wait and see” if a trade will come back in the favour of the original trade. This not only prevents runaway losses but if stop-losses are placed strategically, they will only be triggered once a trade has failed.

Developing a forex trading strategy

Developing a forex trading strategy that is profitable is something which all traders aspire to design. Although it is important to remember that no strategy will give you winning trades 100% of the time, a good strategy will give forex traders a profitable edge in the markets which will be continuously profitable over time. With literally hundreds of methods of trading available, many successful traders usually design their own strategy after testing many of the methods which appeal to their own trading personality. This is also why it may be possible for one trader to use a particular forex system profitably and another to struggle to find success using exactly the same method. They key to this is the fact that some trading systems will suit different styles and types of traders.

Following your own trading preferences

One of the most successful ways to develop a trading strategy, or to try to adopt one of the thousands which already exist, is to follow your own preferences and interests. This creates an initial filter which will ensure that a method is developed from the start by personal preference and trading style. Preferences in forex trading range from the currency pairs that a trader chooses to study, to the types of indicators or price action set-ups that are appealing. Although this sounds fairly obvious, many new traders spend a lot of time trying to follow methods which simply is not suited to their future style of trading. Examples of this are trading uncomfortably low timeframes or using flashing indicators when your underlying preference has always been price-action candlestick and daily charts.

Social networking and forex trading

Some brokers have also allowed social networking to assist traders in finding a suitable trading strategy. Forex brokers such as eToro allows its clients to view and follow successful traders. Members can display their performance and profitability to other traders and, although many will not disclose their precise strategy, it provides a good way to follow experienced traders and to develop a trading method based on this. The software for these trading platforms even allows for automated trading for each and every trade of a followed trader. This method of automated trading is unlikely to help develop a trading strategy of your own, and it will tie you to the trading successes of another trader. Using a platform such as this, however, will allow traders who are looking to develop strategies based on price action to search and follow the success of likeminded traders and provide a valuable tool to developing an independent strategy.

Another perspective on forex trading strategies

Some of the most successful traders consider the strategy as one of the least important elements to successful trading and they may have a point. They put mush more emphasis on money management and, for example, the risk-to-reward ratio of each individual as the most important factor in successful trading. They also point to the psychological elements of trading and the ability for those with a forex trading strategy to develop their control over the two drivers of fear and greed which have a strong influence on all trading decisions.