We are what we think; all that we are, arises with our thoughts; with our thoughts, we make the world.

Psychology of the Forex

Trading the Forex Market can be a stressful occupation. Maintaining a calm approach will benefit the Forex Trader. Trades based on emotion, fear, greed or desperation are destined to fail. A great book to read is “Trading in the Zone” by Mark Douglas.

Trading the forex is only 20% skills and 80% emotions. You must learn to control your emotions if you are going to be successful. My mentors, at Market Traders Institute, http://www.markettraders.com/landings/forexIQ/forexIQ.aspx?id=THEFOREXMOM(Blog), have done a great job in helping me understand this. It has made a big difference in my trading success.

A lecturer, when explaining stress management to an audience, raised a glass of water and asked; ‘How heavy is this glass of water?’

Answers called out ranged from 20g to 500g.

The lecturer replied, ‘The absolute weight doesn’t matter. It depends on how long you try to hold it.  Continue reading

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1) The more complicated the trading system the better chance you have at succeeding.

Just the opposite. The simplest solution is often the most effective. Any time you add another item or variable you introduce another point of failure. Keep Occam in mind when developing a trading strategy.

2) The more I learn the more I earn.

Learning is never a bad thing… however… there’s no such thing as a PHD in trading. Once you developed a system that works stick to it. Read and learn for the sake of personal gain. The Holy Grail of trading doesn’t exist so you can stop searching for it.

3) Mathematicians and people with science acumen make better traders.

Do I have a great example of this flawed logic. Long Term Capital. Trading is as much about emotion as it is about logic. Emotion can’t be quantified. If this statement had any validity there would be a lot of MIT graduates on the Forbes list.

4) You win more often by listening to analysts comments.

There are some very good analysts in the Forex world. However NONE of them know where the market is going. Trade based on a trading plan that you’ve tested and are comfortable with. If you find your trading decisions are being altered by reading analysts comments then stop reading them.

5) Trading is exciting.

Only in the movies. Sitting for hours watching charts and reading economic reports – I can hardly contain myself. If you experience the same rush from trading as you do from gambling then you are probably gambling.

6) Great traders are born with an innate trading skill.

This sounds absurd but there are a lot of people who truly believe certain people are born traders. The last time I checked geneticists have yet to uncover the enigmatic trading gene. This nonsense undermines the hard work successful traders put in to winning.

7) After each loss I double up on the next trade. After losing 3 in a row my odds of losing on the next trade are minimal.

Nope. Doesn’t work that way. If you flip a coin 100 times the 101 flip is still 50/50. Trading a small percentage of your account on each trade is the only way to survive your systems drawdown. Don’t fall prey to the gambler’s fallacy.

9) All Day traders lose money.

You will see this one everywhere. Price action is the short term is unpredictable. Studies have proven it doesn’t work. Spreads make it impossible to win. Support and resistance are meaningless. Day traders don’t make as much. The list goes on and on. Yet every day a small percentage of traders beat the market. If one person can be successful at day trading then so can two. Don’t let others project their inadequacies on you.

10) Stops tighter than 40 pips will result in failure.

Your stop should be based on your system. Be cautious of anyone issuing absolutes – especially in the trading world. The time frame you are trading should determine your stop. Longer term traders will naturally have wider stops.

11) Price action in the short term is random.

Who defines short term? If you have any evidence that price is random on any time frame please forward it to me. The information needs to be quantifiable and longitudinal. It’s important to point out that we don’t have empirical evidence to support our claim either – however – if you look at price action on a 5 sec time frame or a 4 hour time frame similar patterns emerge. If one pattern can be seen on a very short time frame then by definition random can no longer apply.

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1) Knowledge Acquisition

Great traders are voracious learners. Most professional occupations have a learning curve. Doctors, lawyers, criminals, etc.. often study years to refine their craft. Novice traders often believe they are immune to such time intensive studies. Don’t fall prey to such ignorance – study the markets, put in serious chart time, read and learn from those that are winning.

2) Money Management

This one is simple. Trading more then 2-5% of your account on any one trade is account suicide. Let’s assume you start out trading a $1000.00 mini-account. Your system has a 30 pip stop loss. The maximum you should risk on any one trade is a dollar per pip. The market will forgive a lot of things – bad trades, bad days even bad weeks but without the capital to withstand the drawdown your trading career with be short lived.

3) Simplistic Strategy

Have you ever noticed Forex scam sites often provide a unique system that only they have? Additionally – these systems are only known by a hand full of successful traders. Your system should do just the opposite. I use pivot points, psychological levels and trend line breaks because large institutions follow these levels. As a retail trader your goal should be to pick up the pennies in front of the steam rollers. Keep Occam in mind when adopting any trading system. Leave the over complicated systems to the guys at Long Term Capital.

4) Trade During Prime Time

One of the biggest benefits of the currency markets is its hours. It’s open 24 hours a day 5 days a week. This is great for trend analysis but not for trading. Don’t let these extended hours fool you. Only the biggest players trade during the prime hours… so should you. Keep in mind that only 14% of all trades occur outside of non-financial institutions. That’s where the retail trader lives. Since we only trade the EURUSD we only trade between 2:00am and 11:00am EST. This time period covers the European open and close, the open of the US session and the overlap between the US session and the European session.

5) Follow Your Trade Plan

You don’t know where the market is headed. Don’t guess. Hope isn’t a strategy. Once you adopt a trading strategy that fits your trading style stick to it. Leave your ego at the door when you begin your trading day. This is one of the most difficult things to overcome. The old adage plan your trade and trade your plan is very important. When you trade outside your plan you will lose.

6) Double Your Demo Account

Almost every Forex trading platform offers demo accounts. When you can double your demo account you are ready to trade real capital. Additionally – after your double your demo account trade the first few months of you real capital using micro-lots where each pip equals a small dollar amount. This will help ease the emotional impact of trading real capital.

7) Trade with the Trend

All those little axiom’s about the trend exist for a reason – the trend is your friend… trade with the trend until it bends… trade the trend or lose in the end – you get the idea. These exist for a reason. They are true. Use long term trend analysis to determine market direction. When you trade with the trend your chances of success are greatly enhanced.

8 ) Set Realistic Expectation

What’s realistic? If you can return 5-8% a month you are doing great. While this may seem like a relatively small goal very few traders can achieve this month after month. If you set unrealistic goals – say 20% a month you better be sitting beside John Arnold because that’s about the only way your going to see that kind of return.

9) Post Trade Analysis

When the trading day is over take a few minutes to analyze what happened. Did you follow your trading plan? Was your analysis accurate? Why? Why not? At the end of the week spend some quality time looking over the trades you placed during the previous week. How many trades did you take? Are you over trading? Many traders find it advantageous to keep a journal of their trades and their thought process for taking or not taking the trade. In a very short time you will see patterns emerge that will aide you in fine tuning your trading.

10) Predetermined Profit Targets and Stops

Setting your stop loss is a must. Intra-day traders usually use a 20-40 pip stop. After you’ve adopted a system and spent hours watching the chart you will know where your stop should be. Once you’ve settled in on a stop never move it. One more time – never move your stop! Remember that capital accumulation is secondary to capital preservation. On the other side of the equation set profit targets prior to entering your trade. Utilizing pivot points will always provide you with realistic profit targets.

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1. I objectively identify my edges.
2. I predefine the risk of every trade.
3. I completely accept risk or I am willing to let go of the trade.
4. I act on my edges without reservation or hesitation.
5. I pay myself as the market makes money available to me.
6. I continually monitor my susceptibility for making errors.
7. I understand the absolute necessity of these principles of consistent success and, therefore, I never violate them.

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  1. Mechanical – learn the simple rules for trading
  2. Subjective – Create your own rule for trading
  3. Intuitive – Being able to sense where the market will be going.

In the mechanical stage you need to:

  1. Build the self-trust necessary to operate in an unlimited environment.
  2. Learn to flawlessly execute a trading system.
  3. Train your mind to think in probabilities (the five fundamental truths).
  4. Create a strong, unshakeable belief in your consistency as a trader.

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We have to be rigid in our rules and flexible in our expectations.

A probabilistic mind-set pertaining to trading consists of five fundamental truths.

1. Anything can happen.
2. You don’t need to know what is going to happen next in order to make money.
3. There is a random distribution between wins and losses for any given set of variables that define an edge.
4. An edge is nothing more than an indication of a higher probability of one thing happening over another.
5. Every moment in the market is unique.

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The first is the focus of this chapter: learning how to keep your mind focused in the “now moment opportunity flow.”

The second hurdle has to do with the division of labor between the two halves of our brain. The left side of our brain specializes in rational thought, based on what we already know. The right side specializes in creative thought. It is capable of tapping into an inspiration, an intuition, a hunch, or a sense of knowing that usually can’t be explained at a rational level.

I must use both sides of my brain, the left side or logical side to analyze the market, and the right side or creative side to tap into the consciousness of the market. I must keep my focus on the “now moment opportunity flow” and remove external distractions from my mind. I must enter the trading zone so I am balanced in the center between fear of the market and overconfidence of the market.

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If there is such a thing as a secret to the nature of trading, this is it: At the very core of one’s ability 1) to trade without fear or overconfidence, 2) perceive what the market is offering from its perspective, 3) stay completely focused in the “now moment opportunity flow,” and 4) spontaneously enter the “zone,” it is a strong virtually unshakeable belief in an uncertain outcome with an edge in your favor.

Not predefining your risk, not cutting your losses, or not systematically taking profits are three of the most common—and usually the most costly—trading errors you can make.

The most effective and functional trading belief that he can acquire is “anything can happen.”

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I do NOT tell the market where to go, I must listen to what the market is telling me.

The market does not threaten me and I must not perceive the market as painful. I must view the market as a game… games are fun.

I must act without resistance or hesitation, but with the appropriate amount of positive restraint to counteract the negative effects of overconfidence or euphoria.

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Trading in the zone means that I have developed enough experience at trading that I can trade without fear. I know that I will sometimes loose when I trade, but I have already established a track record of winning more than loosing.

I am comfortable enough with my trading strategy that I do not have to stress about it, it is like breathing to me. I do not waste time second guessing myself. I plan my trade and I trade my plan.

I take responsibility for my trading and I focus on following my plan. If I follow the plan and the market still goes against me, I take pride knowing that I did it right. The backtesting I have done previously gives me the confidance that the market will only go against me a small percentage of time. Next time, I will win!

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