Emotions play a significant role in the world of Forex trading, influencing decision-making and overall performance. Many traders understand that technical expertise alone is not enough; mastering trading psychology is equally crucial.
In this guide, we explore the intricate relationship between emotions and trading. By understanding the impact of emotions and learning to keep them in check, traders can enhance their decision-making, maintain discipline, and increase their chances of success in the dynamic Forex market.
Trading should be seen as a business where you need to incur expenses to generate profits. One should not get emotionally affected by the losses and accept that these losses are ‘expenses’ necessary to be able to generate profits.
Casting out the emotions that naturally come with losses is the key factor for consistent profitability as that is the reason why impulsive trades without a plan and poor decision-making follow. Therefore, a very strict trading plan is crucial to not sink into your emotional decisions.
The Importance of a Trading Plan
Having a well-defined trading plan is paramount to success in Forex trading. A trading plan serves as a roadmap, outlining your trading goals, risk tolerance, entry and exit strategies, and more. When emotions run high, a trading plan acts as an anchor, keeping you focused on your objectives and preventing impulsive actions driven by fear or greed.
By following a trading plan, you can maintain discipline, consistency, and logical decision-making, reducing the influence of emotions on your trades. To assist our fellow traders, let us go ahead and give you all a layout of the plan you may follow that can come in handy:
Before we delve into it further, let us first visualize how the Emotion Cycle plays out when a trader is exposed to the market:
In the above image, we have demonstrated the 14-stage emotional cycle where at every stage of the trade, the trader feels a different emotion. If a trader only starts to look at it objectively by truly understanding the market cycle and comes to term with the fact that losses are bound to happen, it can potentially improve the discipline in trading and hence consistent profitability.
Now you are all probably wondering ‘I am aware of all this, but what measure should I take to overcome it?’ Let’s make this blog more useful by identifying some key psychological/emotional aspects to keep in check while trading.
Confirmation Bias
Confirmation bias is the tendency to interpret new information so that it becomes compatible with our existing trade idea, market direction, or trading strategy. We filter any information that contradicts our existing views and only see what we want to see, hear what we want to hear, and read what we want to read.
Under the confirmation bias, we sometimes even add more reasons outside our trading system as to why we may be more correct, thinking this increases the chance of realizing a winner. This leads to inconsistency as we only really notice the market condition after it has presented itself, constantly changing by adding or discounting trade criteria on each situation based on what the market presents at the time.
Clustering Illusion
Pattern recognition is an essential skill for a trader. However, traders could be very sensitive during live markets. They filter out contradictory information and only see what they want to see. Never attempt to change, add or remove criteria for a pattern or a trade based on recent price action only to force your way getting into a trade. It is advised to trade objectively, and formulate a trading plan/model which represents exactly what your pattern should look like; all else should be invalid.
Sunk cost fallacy
Traders do not like to be wrong in the markets. When traders are so attached to their trade idea, they think of absolutely no reason why it shouldn’t work. They continue to think the trade ‘should’ eventually work out in the end as the trade goes even deeper into drawdown. The worst thing any trader could do while in drawdown is to widen their stop or increase their exposure to losing position thinking they are getting a better deal. It is advised to always stick to your initial risk and avoid getting attached to your position.
Loss aversion
A human brain is naturally designed to fear loss more than it values gain. Losing 100$ costs a trader a greater amount of pain than the opposite equivalent happiness or delight a 100$ gain could give. Based on a study, the pain of losing is psychologically about twice as powerful as the pleasure of gaining. For having a minimum of 50% strike rate, a trading system should follow at least a 1:2 risk-reward ratio in order to avoid the pain of losing.
Cognitive dissonance
When things do not go as expected, we sometimes reinterpret what has happened retrospectively or based on the outcome. On a losing trade, we tend to find reasons why the trade has gone wrong, even though it was perfectly valid in the first place. Conversely, on a winning trade, when we have made money on an invalid trade, we justify ourselves that we have made a good decision even though the trade did not fit our methodology beforehand. Having this mindset leads to inconsistency as we evaluate the quality of the trade based on its individual outcome and not on the process or trading decision prior to execution, regardless of the outcome.
Below we demonstrate a comparison through a visual representation of how the equity curve looks like when a strict trading plan is observed with emotional trading:
When you are observing the following three aspects, it directly points to the fact that your trading is being ruled by emotions:
Now let’s move on to shed light on other factors that traders must be always vigilant about:
Avoiding FOMO
Avoiding FOMO (Fear of Missing Out) is a critical aspect of managing emotions in Forex trading. FOMO often arises when traders see others profiting from certain trades or witnessing sudden market movements. The fear of missing out can lead to impulsive and irrational decision-making, as traders rush to enter trades without proper analysis or risk assessment. To overcome FOMO, professional traders prioritize sticking to their trading plan and strategy, focusing on their own research and analysis rather than succumbing to external influences. They understand that patience and discipline are key and that chasing after short-term gains based on FOMO can often result in poor trading outcomes.
The Risk-Reward Ratio: Balancing Fear and Greed
The risk-reward ratio is a fundamental concept in Forex trading that determines the potential profit compared to the potential loss on a trade. Emotions like fear and greed often tempt traders to deviate from their initial risk-reward plan. Fear may cause traders to exit winning trades prematurely, while greed may push them to hold losing positions for too long, hoping for a reversal. Understanding the importance of maintaining a balanced risk-reward ratio helps traders overcome emotional biases and make rational decisions based on probabilities rather than emotions.
The Challenge of Losing Money
Losing money is an inevitable part of trading, and it can evoke powerful emotions such as frustration, anger, or self-doubt. How traders handle losses is crucial to long-term success. It is essential to view losses as learning opportunities and not let emotions cloud judgment. Analyzing losing trades objectively, identifying mistakes, and adjusting your strategies accordingly can help you grow as a trader and prevent emotional biases from affecting future trades.
The Power of Trade Journals
Keeping a trade journal is a valuable practice for professional traders. It allows you to record and analyze your trades, including the rationale behind each decision, entry and exit points, and emotions experienced during the trade. By reviewing your trade journal regularly, you are able to gain insights into patterns, strengths, and weaknesses in your trading approach. Additionally, the act of journaling itself helps in processing emotions and developing self-awareness, enabling you to make better-informed trading decisions.
Insights from Market Wizards
“Market Wizards” refers to highly successful traders who have achieved remarkable results in the financial markets. By studying their experiences and insights shared in books and interviews, traders can gain valuable perspectives on trading psychology. These experts emphasize the importance of discipline, emotional control, and continuous learning. Learning from the experiences of market wizards can inspire professional traders to develop a more resilient mindset and approach to trading.
Trading in the Zone: Achieving Optimal Performance
“Trading in the Zone” is a concept coined by Mark Douglas, highlighting the mental state where traders perform at their best. Achieving this state requires discipline, focus, and emotional balance. By actively managing emotions, traders can stay present, make clear decisions, and avoid the detrimental impact of impulsive or irrational behavior. Techniques such as meditation, mindfulness, and visualization can help traders attain and maintain the optimal mental state for trading.
For interested readers, we would highly advise you to read this book as it gives insight into various useful concepts/topics. It highlights potential emotional traps and is really useful in helping you master discipline in trading.
Conclusion
We hope this article gave you insight into how trading with emotions can be detrimental to your trading.
Understanding and effectively managing emotions is crucial for professional traders in the Forex market. By following a trading plan, balancing risk and reward, embracing losses as learning opportunities, maintaining trade journals, seeking insights from market wizards, and striving for a state of “trading in the zone,” traders can navigate the psychological challenges of trading and increase their chances of success in the dynamic and volatile world of Forex trading.
