You might have already heard or read about the importance of trading psychology, but I believe this remains the single most overlooked and yet important aspect of becoming a profitable trader.
Ask any profitable trader about the book 'Trading in the Zone' by Mark Douglas and the odds are they have read it, more than once. The reason is simple, once you understand that your single biggest hurdle to becoming a profitable trader is your human nature, you will have taken the first and most important step towards achieving trading success.
In this blog post I will share with you some of the most important trading psychology aspects that I have personally learned over the years. I believe this will greatly assist you in your own journey by helping you identify and eventually overcoming the mental hurdles that are keeping you back.
The first thing any trader should understand is that trading without a plan, that is to say just getting in when the price 'seems' ready to turn because it 'looks' oversold or vice versa is fatal. As the saying goes; failing to plan is planning to fail. It is simply impossible to correctly time the markets consistently, and even if you were able to do so, the volatility will inevitably cause you to lose any gains you might have made due to not having clearly defined your stop loss and take profit levels beforehand. And for Pete's sake don't revenge trade! This means trading larger and larger positions to make up for previous losses. Stop sabotaging yourself.
Almost every trader I know (including myself) have probably learned this the hard way. How often have I heard the conversation that if only I took the opposite side of every trade I would of been rich by now. The truth is, even if you took the opposite side of those trades, odds are you still would of lost money. So how can this be?
One study by the brokerage firm FXCM revealed that at least 83% of traders were losing money over a 12-month period, yet they still managed to have a 50-60% win rate.
This shows that it isn't necessarily the direction of the trades that is the problem. What they found is that most of these losing traders are cutting their winning trades short and letting their losing trades get way to big, thus effectively giving them a negative risk to reward ratio.
And the reason people do this comes back to the fact that as humans we are predisposed to fail at something like trading due to our psychology. Let me provide you with a quick example. I will present you with two scenarios, for each scenario either choose Option A or Option B.
Now chances are that you chose Option A for both of the scenarios above. How do I know this? Well aside from this being evident from a physical study that was carried out, everyone knows that as humans we do not like losing, you can read up more about what has been termed prospect theory if you like.
You see in scenario A you face the option of being guaranteed the pleasure of walking away with $400 with no risk of loss. This would be the obvious choice for any rational person. The analogy here, is that just like with a trade starting to go into the green we immediately start feeling the pressure to take profit of the table before the market direction reverse and we end up losing our gains. However looking at the odds presented in scenario A, repeating our 'rational' choice 10 times, we would statistically have ended up with only $4000 vs $5000.
Similarly in scenario B, being presented the option to avoid an immediate loss and gain the possibility of 'maybe' losing nothing again seems like the rational option. Unfortunately if you were to keep choosing this option 10 times you would statistically have lost $5000 vs $4000. This is the same with losing trades where we choose to avoid taking a loss only to end up with a much bigger loss.
It is also interesting to note that this is probably the same reason many people seem to make money when they trade using a demo account but as soon as they start trading with real money they just cannot remain profitable. With 'fake' money there is no pain in losing.
Getting back to the FXCM study, in conclusion they found that simply having a risk to reward ratio equal or greater than one, increases your odds of profitability almost 3 fold.
So how do you determine your risk to reward ratio and why is this so important? Let me explain, a risk to reward ratio is basically your maximum possible loss (as determined by your stop loss level) divided by your minimum possible gain (as determined by your initial take profit level). And this brings me back to the importance of having a trading plan! A trading plan is basically a checklist helping you to execute and manage your trades according to a predefined set of rules. Here is an example of a very simple trading plan to enter a long position based on a very basic Fibonacci pullback strategy:
Price is above the 200MA
Price has retraced 61.8% from the previous swing high and coincides with previous horizontal support levels
Strong engulfing green candle has formed on the Fibonacci level
Risk to Reward Ratio:
Take Profit Level is 100pips away from Entry
Stop Loss Level is 50pips away from Entry
Risk Reward Ratio is thus 1:2
Based on R:R ratio meaning either my stop loss or target is triggered. Do not and I repeat DO NOT ever move your stop loss further away. Also never add to a losing trade thinking you will average into a better price. This will not work. If however the price have moved well into profit, you can under certain conditions move your stop loss to break even, just make sure you allow for price volatility.
With any trade you have 5 possible outcomes:
Break even trade
Be sure to eliminate number 5! You have to realize that trading is all about probabilities and not certainties, this is a point Mark Douglas strongly drives in his book. You can never control the outcome of a trade but you can control your risk.
Most traders abide by the rule of never risking more than 2% of their account on any given trade. This means that even after 35 consecutive losing trades you still have half your capital left! And hypothetically speaking were you to lose 100 times in a row, you would still have 13.5% of your starting capital left.
Now let's consider you have a low average win rate of 40% but never take trades with a risk to reward rate of less than 1:2 and also never risk more than 2% of your account. This will mean that were you to start with a $10,000 account, after 100 trades you will have made between $3700-$4500 assuming you stuck to your rules.
So my take home point is this, define your risk, trade with a plan and understand that trading is a numbers game that is all about discipline and consistency.
If you are looking to learn more about risk management techniques, or looking for ways to never again have to worry about executing trades without a plan then contact me or feel free to visit my site www.FXautomate.com for the latest in trading tools and resources.