No one pretends that learning forex trading is a walk in the park: there is a lot of complex technical and financial information to get to grips with, and it’s a continual learning curve. However, often it is not a lack of knowledge or skills that lets traders down, but a poor mastery of their emotions.
Here’s a look at forex trading psychology, and how to beat your emotions and bring your best trading mindset to the table.
How your emotions affect your trading decisions
Forex trading holds a strong allure for people who want to grasp the opportunity to make a lot of money, and this means that intense emotions are subconsciously at work. The prospect of financial independence appeals to almost everyone: it brings freedom and security, and access to a more luxurious lifestyle.
Therefore powerful emotions such as fear or greed can kick in when traders are navigating a volatile market or chasing a trade that’s on the up. New traders may be prone to underestimating the subconscious influence that their emotions can have, and this has potentially disastrous consequences.
Humans have evolved over thousands of years to have a strong response to fear of losses, and have an instinct to build up surplus supplies as a survival insurance policy. When we sense that our precious assets are under threat, the body’s ‘fight or flight’ instinct kicks in.
This is also known as the stress response, as the sympathetic nervous system responds by pumping adrenaline around the body. The heart beats faster, blood pressure rises, and extra oxygen reaches the brain and muscles. This physiological reaction is useful if you are fleeing a predator or need to get yourself out of the way of an oncoming vehicle quicktime.
However, in non-life threatening situations such as forex trading, a burst of adrenaline is less helpful. It can prompt traders to make impulsive decisions, when a successful trade outcome requires detached and logical reasoning.
No matter how much effort they have put into crafting a trading strategy and risk management plan, an inexperienced trader will frequently abandon it at the first ripple of the market. This can result in a poorly executed trade, and despite a resolve to do better next time, the trader will go on to repeat the same mistake over and over.
It’s not possible to change an instinctive response that humans have hardwired into their system, but it is certainly possible to learn how to be aware of the triggers and signs, and put strategies into place to manage them. Here’s a closer look at some of the most common emotional traps that traders fall into, and how to avoid them.
Fear
The fear of making a loss is at the heart of many poor trading outcomes. It can prompt traders to close positions too early, missing out on potential profits. It can also cause traders to hold on to a losing setup for too long in the hope that the market will rebound, rather than cutting their losses.
Greed
Greed can take over when a position is doing well, and a trader might over leverage or hold on for too long in order to make a bigger profit, ignoring their risk management strategy.
Overconfidence
Hitting on a winning streak can be a great ego booster for new traders. However, this can easily spill over into a sense of invincibility and the taking of unnecessary risks. There’s no such thing as luck or instinct in forex trading: the key to consistent success is always careful risk management.
Revenge trading
A loss can provoke feelings of anger or frustration, and this can lead to impulsive revenge trading in order to try to reclaim the loss. These trades are based on emotion rather than research and rational thought, and therefore should be avoided.
How to develop a good trading mindset
Prioritise your risk management strategy at all times
When you recognise yourself experiencing one of the emotions described above, such as fear or greed, your first line of defence should always be to take a step away from the screen and refer to your risk management strategy.
Make sure that you are never risking more money in a trade than you can afford to lose, as this is a sure way to become emotionally overinvested in the outcome.
Always calculate your risk to reward ratios and apply moderation to position sizes. Use stop-loss orders and take-profit levels to determine the parameters of each trade and hedge against catastrophic losses.
Learn from the characteristics and habits of successful traders
There is no such thing as a 100 per cent success rate in forex trading: even the best traders will make losses on many of their trades. Therefore you should not define success as the simple binary of failure, but rather as a set of behaviours that result in a consistent performance over the long term.
Good traders are highly disciplined
A good trader will have the discipline to follow a trading plan at all times, even during turbulent periods in the markets or wider economic or political picture. Likewise, they are always able to adhere to their risk management strategy and will not give in to panic or herd mentality if there are unexpected market developments.
Good traders are emotionally intelligent
We can all improve our emotional intelligence, no matter what innate personality traits and characteristics we are born with. One of the key characteristics of emotionally intelligent traders is self-awareness. This allows them to be honest about their own fallibilities, such as a tendency to be loss-averse, or give in to moments of anger or panic.
It is impossible to completely suppress all emotions when we are trading, because as we have already discussed, these are gut reactions that have an important primary purpose. The key is to be honest and self-aware enough to recognise when your emotions are biasing your trading decisions, and to mentally pivot back to a more neutral mindset.
Highly emotionally intelligent people are also resilient: they don’t brood on failure, but work out what went wrong and bounce back better. This mental toughness is essential for forex trading, because many trades will fail to hit your targets. If you let your emotions get in the way, you will continually be making biassed decisions that result in further failure.
Cultivate a positive outlook, and always remember that the emphasis is on a consistent performance over the long term, and there will always be a way to get past any obstacles and temporary setbacks. Finally, good traders are open to the views of others, but also trust their independent judgment.
Good traders learn from their mistakes
We all make mistakes, and what matters most is how we react to them. Carrying on obliviously will soon lead to the repetition of the mistake, but on the other hand, taking it to heart will risk a loss of self-confidence and momentum. The key is to see a mistake as a learning opportunity rather than a personal failure.
Keeping a trading journal can be an excellent way to reflect on and refine your progress as a trader. Use the journal to record the factual information about each trade, such as the currency pairs, date and time, position size, and so on. However, expand on this to include your reasons for placing the trade, and reflect on the outcome.
Review your journal entries regularly to gain insights into your trading style, and to identify patterns in your worst and best performing trades. If there are areas for improvement, make adjustments to your trading strategy after careful consideration. This will enable you to evolve as a trader while taking a prudent approach to risk management.
Practice with a demo account
There is a very steep learning curve from learning the theory of forex to diving into a live trading situation. One of the best ways to bridge the gap is to practice with a demo account first. Prop firms such as FTUK offer a 14-day free trial, which will give you access to a funded account in simulated live market conditions.
This gives you the opportunity to test out your trading strategy, and also gives you a taste of making decisions when the pressure is on. However much we read up about trading psychology, the only way to forge your trading mindset is in the heat of the battle.
Yes, you will make mistakes along the way, but you won’t have the pressure of dealing with real money (any profits or losses you make will be virtual). If events don’t go your way, you’ve still gained an insight into how you handle the heat, and you can step away and plan what you will do differently next time.