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How to Manage the Emotions of Trading

By , Forex Trading Instructor
16 March 2012 07:00 GMT

Trading is difficult. The goal of this article is not to make trading seem less difficult; but rather to highlight the fact that many new traders can often-times become their own worst enemies, making trading even more difficult than it already is.

To illustrate how this can happen, try to think back to the last time that you were very angry; the last time that you were really mad about something.

Then think about what caused you to be mad.

Then think about what you did, and how you felt after you first became mad.

For many, when they became mad they lost control to some degree; as in – they weren’t able to draw upon their highest of mental faculties to ‘fix’ what was making them upset. This is a trait that can often hinder us from accomplishing our goals.

For traders, this issue can be very problematic.

Imagine you’ve just taken a trade ahead of Non-Farm Payrolls, with the expectation that if the reported number is higher than forecasts, you will see the price of the EURUSD increase very quickly; enabling you to make a hearty short-term profit.

NFP comes, and just as you had hoped – the number beats forecasts. But for some reason, price goes down!

You think back to all of the analysis you had performed, all the reasons that EURUSD should be going up – and the more you think, the further price falls.

As you see the red stacking up on your losing position; emotions begin to take over. These are often the same emotions we feel if we had just been in a shocking accident, or a fight with another person.

This is the Fight-or-flight instinct, and we have it for a reason.

In psychology circles, the fight-or-flight instinct is often regarded as being a key part of the human psyche; built to protect us in times of stress.

The theory states that when a person encounters stress, their brain quickly makes calculations (so quick that the person doesn’t even notice) to make a determination as to how that stress should be handle.

In some situations, when the mind deems the situation as too stressful to attempt to manage – we run.

In other situations, in which the mind feels as though we can make an impact with our actions – we fight.

This is often why we do or say things we regret when we fight with each other; in some cases, it really is out of our control.

This is the fight-or-flight instinct; always part of every one of us constantly seeking to protect us in times of stress.

In trading, we can get quite a bit of stress. When a position begins to turn against us, that's when we begin to feel it. The red arrows on the chart accompany all the fears of failure that rush through our brains in nanoseconds.

As the loss continues to stack against us, that stress becomes more and more profound; making the concept of taking action even more intimidating.

And this is precisely how our fight-or-flight instinct can negatively affect us in trades, as we allow ourselves to make decisions in extremely stressful states that, often-times, don't do us any favors.

The decisions we make in these situations are often called ‘knee-jerk reactions,’ or ‘on-the-fly decisions,’ depending on how they turn out. Bad trades are often reactions, while good trades are often decisions.

Professional traders usually don’t want to take the chance that a rash decision will damage their account; or said another way – they want to make sure one knee-jerk reaction doesn’t ruin their entire career. They often go through much practice, and many trades in an attempt to soften this emotional reaction to the stress of an open trade. Below are some of the ways that can help traders do this.

Plan your success

One of the things that professional traders do to ensure discipline during these trying times is to plan out their approach. The old adage ‘Failing to plan is planning to fail,’ can really hold true in financial markets.

As traders, there isn’t just one way of being profitable. There are many strategies, and approaches that can help traders accomplish their goals. But whatever is going to work for that person is often going to be a defined and systematic approach; rather than one based on ‘hunches.’

Planning each trade, and planning how you want to react in each situation that takes place in those trades can greatly help a new traders manage the emotions that come with speculation.

In the DailyFX Education group, we get to work with many new traders. One of themes we’ve noticed with those new traders that are successful is the usage of a Trading Plan.

The differences between new traders using a trading plan, and those not using a trading plan were shocking: So shocking that we wanted to produce resources so that any and every trader interested in writing a trading plan would have everything they need.

I wrote an article outlining many of the areas of the trading plan that traders may want to pay focus to.

Compiling a trading plan is the first step to attack the emotions of trading, but unfortunately the trading plan will not completely obviate the effects of these emotions. Below are a few ways that traders will often attempt to mitigate this damage.

See how others handle the stress

In the DailyFX series, Traits of Successful traders – David Rodriguez, Tim Shea, and Jeremy Wagner set out to discover what separated those who were successful from those who had failed in the Forex market, and the research was shocking.

In the Number One Mistake Forex Traders Make, David Rodriguez found that, shockingly, retail traders were right MORE often than they were wrong; meaning that they were actually on the right side of the trade more often than not.

But what was even more shocking was the fact that, in many cases, traders were taking losses TWICE that of the gain that they were making IF they were right.

The unsustainability of this type of plan should be obvious. If we’re losing 2 dollars for every time that we are wrong, and only making 1 dollar for every time that we are right, we must be right AT LEAST twice for every one time we are wrong.

And that doesn’t even include spread, or slippage, or any other costs that may come about.

If we utilize this style of money management, we often need to be right 3 times for every one time that we are wrong; a 75% success rate.

Most professionals don’t want to expect themselves to be able to pick the right side of the trade for more than 3 out of 4 times.

And keep in mind, for every one loser that cancels out two winners. So if a trader using the above scenario happens to get surprised – well, now they’ve taken a loss.

Needless to say, this is a scenario that many traders have a difficult, if not impossible time digging themselves out of.

The thesis of the Number One Mistake Forex Traders Make is:

Traders are right more than 50% of the time, but lose more money on losing trades than they win on winning trades. Traders should use stops and limits to enforce a risk/reward ratio of 1:1 or higher.

Employ loss limits

This may have special importance to scalpers and day traders, but the Loss Limit has been used for years in an effort to prevent a bad day becoming even worse.

After losing trades, we often feel negativity. After many losing trades, this negativity can often build; reinforced by the thought that ‘its about time I finally win a trade.’

I can not even begin to count the number of new traders that have come to me, regretfully, after blowing an account on one currency pair in a single trading session simply because they were chasing prices.

What usually happens with these folks is that after placing a few losing trades, and getting nowhere really fast, they increase the trade size.

While there is the chance that the trade might work out for you, the fact of the matter is that you are making quick, short-term decisions about future price movements.

The DailyFX Education team places a heavy importance on Money Management, and as we’ve worked with so many new traders we realized the necessity of loss limits.

In the DailyFX Education Course we offer a full module on Money Management, with a full profile and set of rules for new traders to use.

One of the key elements of our Money Management curriculum is the 5% rule; meaning that on any one trade we will not risk more than 5% of our account.

This rule is in place to ensure that one bad day doesn’t end (or cause irreparable damage to) our trading careers.

Lower your leverage

One of the easiest ways to decrease the emotional affect of your trades is to lower your trade size.

Don’t believe me? Remember how it felt the last time you placed a demo trade? It probably didn’t garner much of an emotional affect at all, as there was no financial risk on the trade.

Increasing the trade size, or velocity, will often increase these stress levels as traders are allowing each individual trade to carry to great of an impact to their trading account.

Let me explain.

Imagine a trader opens an account with $1,000 dollars.

Our trader first places a trade for a $1,000 lot on EURUSD.

As the trade moves at ten cents a pip, the trader sees moderate fluctuations in the account. Thirty-two dollars was put up for margin, and our trader watches their usable margin of $968 fluctuate by ten cents-per-pip.

Now imagine that same trader places a trade for $30,000 in the same currency pair.

Now our trader has to put up $960 for margin – leaving them with only $40 in usable margin.

And now the trade is moving at $3 per pip.

After the trade moves against our trader only 14 pips, the usable margin is exhausted, and the trade is closed automatically as a margin call.

The trader is forced to take a loss; they don’t even have the chance of seeing price come back and pull the trade into profitable territory.

In this case, the new trader has simply put themselves in a position in which the odds of success were simply not in their favor. Lowering the leverage can greatly help diminish the risk of such events happening in the future.

--- Written by James B. Stanley

To contact James Stanley, please email Instructor@DailyFX.Com. You can follow James on Twitter @JStanleyFX.

To join James Stanley’s distribution list, please click here.

Additional Resources:

Support and Resistance – On-Demand Video Course

Money Management module -- On-Demand Trading Course

“What is the Number One Mistake Forex Traders Make?”

Trade the News – On Demand Video Course

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16 March 2012 07:00 GMT