This refers to the trader’s mindset when a trade is in progress. It is the emotional part of a forex trader’s decision-making process which is primarily driven by greed and fear of losses. It has been proved that a trader’s success in the financial markets largely depend on his trading psychology. This is because it comes to play in both winning and losing trades, so, emotions largely impact on a trader’s profits or losses.
Trading psychology focuses on the trader and the markets. It analyzes the instincts, emotions, knowledge, experience, skills, and thoughts of the trader in relation to the financial markets.
“If you can learn to create a state of mind that’s not affected by the market’s behavior, the struggle will cease to exist” - Mark Douglas
Here are the dangerous emotions:
Anxiety or fear is one of the enemies of traders. It makes traders believe that they cannot succeed or earn money from the forex market no matter the strategy deployed. So, out of fear, they fail to take the necessary risks in order to win big. It also builds when successive trades resulted in losses; the trader is discouraged and unwilling to take more risks.
Also, many fearful traders quickly exit losing positions but miss out the bigger reversal ahead that would have paid off. Naturally, it is very difficult to watch your hard-earned money go down the drain while hoping that the markets will soon change to your favor. What if it doesn’t happen? Anxiety is not good for any trader as it leads to losses, anger, and depression. Price fluctuations are part of the game; in times of volatility, do not panic but stick to your strategy.
It is common for traders to overtrade by remaining on a winning trade even when it is time to exit and take your profits. Greed is one of the dangerous emotions in financial markets trading. Sometimes greed sets in after winning a few trades, you become convinced that your strategy is flawless, so it is time to go big and win big. Of course, nobody wins them all; when losses result, you will become disappointed.
Becoming a disciplined trader has to do with putting your emotions aside and sticking to your trading plan and strategies when trading. Every trade is risky, so, you must factor risk management into your strategies. Losses must surely come because they are part of the game.
“The hard, cold reality of trading is each trade has an uncertain outcome” - Mark Douglas
By nature, we cannot see the future and so, we are subconsciously guarding our lives and managing risks every day. For example, when driving, we are calculating the safest thing to do at any time; driving slowly in the rain or using a seat belt are all part of risk management. Also, buying an insurance plan, going for medical checkups, eating healthy diets, etc are all part of managing risks.
Risk management is the process of identification, assessment, control, avoidance, minimization or complete elimination of unacceptable risks. In forex trading, the trader cannot control the price direction or market movements but he can make some decisions to minimize risks and reduce bad trades. For example, he can decided which currency pairs to trade, when to trade, volume of trade and when to exit his trades.
The 5 steps to risk management are:
- Objectives definition: what are your trading goals and risk tolerance?
- Identifying risks: The main risk is loss of trading capital.
- Risk assessment: Market risk, leverage risk, interest rates risk, etc.
- Response: Using risk management tools and a robust trading plan.
- Monitoring: trade assessment and improvements.
A reckless trader jumps into a trade with no plan and no exit strategies. He exposes his entire capital to the market risk. This is tantamount to gambling which is a game of chance and luck. But a controlled trader has a rugged trading plan and risk management strategies. He only trades with the amount he can afford to lose.
This is the process of determining the volume of trade required to meet your acceptable risk. Experienced traders advice that newbies should only risk at most 2% of their capital in one trade. Why? It gives you a chance of opening more trades and possible recovery from a losing streak. After a first trade and a loss, your capital should remain big enough to continue learning and trading. But, if your position sizing is high, only a few trades will wipe out your capital.
Drawdown is the reduction in trading capital after a loss. For example, if your capital is $5,000 and after a loss, you now have $4,000; then your drawdown is 20%. With position sizing, should limit your drawdown to 2% after a loss. Bear in mind that the outcome of every trade is uncertain, so, prepare for losses as it is part of trading.
Risk management tools
For every trade, it is important to set ‘stop loss’ and ‘take profit’ level. Stop loss is a risk management tool that tells the broker to close your trades when the price is reached to curb losses. Take profit closes the trade to lock-in the realized profits in order to forestall any reversals. They are both found on every trading platform when placing orders. Depending on the platform, you can set stop loss as prices, percentages, points or trailing stops.
A trailing stop order is an order that moves with favorable trades allowing the trader to make more profits but closes out if the prices reverse and triggers it. For example if you set a trailing stop order at 30 pips on the EURUSD on a long position at 1.08786. If the price increases favorably and rises to 1.09446; which is a gain of 66 pips. The trailing stop moves from 1.08486 to 1.08786. It continues going higher with the good trade and will not go down until the market price reverses and then triggers it to close out the position.
This means the ratio of your target profit compared to the amount you are risking if you lose the trade. Setting a good risk-reward ratio will depend on your trading strategy and the market conditions. But, it is ideal to keep it low like 1:3. For example, if you set your stop loss at 10 pips and set your take profit at 30 pips; the risk-reward ratio is 1:3. You also have to factor-in the spread charges.
Leverage and Margin
Leverage enables a trader to multiply his capital and market exposure. Margin is the amount of money you need to put forward before you can open trades worth more than your capital. During a trade, the broker locks the margin while allowing you to open trades worth multiples of your capital.
Example: If your account balance is $5,000; your broker offers a leverage of 1:200 and you wish to open a trade worth $100,000.
Margin = amount/leverage
Margin = 100,000/200 = $500; which represents a margin of 0.5%
So, only a margin of $500 is required to open a $100,000 trade which gives the trader the potential to make higher profits. It also means that $4,500 is still available to open more trades.
But be careful with leverage because it is notoriously referred to as a ‘double edged sword’. Why? Just as it multiplies profits, it equally multiplies losses when on a losing trade. So, a high leverage can easily wipe your account. Beginners should start with low leverage.
Emotional trading is disastrous, a disciplined trader has no fear, greed, anger or anxiety while trading. Every trader wins or loses, accepting the risk and managing them is imperative. Constant learning and improvement is part of a trader’s life and trading journey.
Risk management means that you have to understand, accept and find way to reduce the losses that come with forex trading. Always set ‘stop loss’ and ‘take profit’ values on every trade. As a newbie, do not risk more than 2% of your capital on a trade. Leverage can multiple or deplete your capital; use it with care. Set your risk-reward ratio according to your trading style or market conditions.