The Psychology of Forex Trading
So, you've found the perfect system for you. You have thoroughly tested it and put an appropriate risk management strategy in place. You have shared it with others and nobody seems to be able to find any holes in your logic or any of your back testing. You're now ready to make your fortune trading in the Forex market, right? But when you try you simply can't, for some reason you still fail. Some key ingredient is missing, but what? More often than not the answer to this question is psychology, it's your state of mind that is not right. Sure, you have your system and strategy prepared, but are you mentally prepared for trading the Forex market?
Trading is, in theory at least, very simple. Trading is not exactly quantum physics or rocket science; but psychologically trading is something that most people will find very difficult. Intellectually trading might be very simple, emotionally it is very difficult, and this is especially true of trading Forex.
The FX market is one of the most difficult types markets to trade as it is driven by macro economic fundamentals and global politics and therefore tends to trend well. Markets that trend well might be the easiest to build mechanical trend trading systems for, but for most people mechanical trend trading systems are actually the most difficult of all mechanical trading systems to actually follow.
Trend following rules are rules that most people will find very difficult to actually stick to as these rules go against human nature even if they do seem like a very sensible rules to the intellect. The human brain is simply not wired for trend following and sticking to the rules of any trend following system goes completely against the human psyche; traders who try and succeed at trading with trend following systems are not likely to be successful until they conquer the beast within.
The single biggest reason for trend following being so difficult psychologically is related to the amount of pleasure people get when they win and the amount of pain they suffer when they lose. When the amount won and the amount lost are equal the amount of psychological pain caused by the losses and the amount of psychological pleasure gained from the winnings is not equal. People tend to experience far more emotional pain and disappointment from a 100 pip loss than they get pleasure and satisfaction from a 100 pip gain. And as most readers will probably know, most trend following systems actually produce more losing trades than winning trades and are only profitable because the size of the winning trades tends to vastly out weight the size of the losers; in fact, it is not uncommon for a trend following system to catch a single large trend that pays for an entire years losses and more. The problem with this for a trader however is that the one can spend a long time waiting for one of these big moves and while they are waiting they may suffer a long string of losses. With trend following losing streaks can last for months and these losing streaks will often grind traders down and wear them out emotionally causing them to quit and give up on their systems before the next strong trend begins. The cash from a single big winning trade might very well more than make up for the losses from a string of losing trades, but the pleasure and satisfaction one gains from a large winning trade will most likely not make up for the emotional stress and disappointment that one experiences from a string of small losses.
Another reason that trend following goes against human psychology is that human beings, regardless of what their logic and reason tells them, generally don't want to maximise the amount they win and minimise the amount they lose. What humans actually tend to want to do is maximise the frequency with which they win and minimise the frequency with which they lose. Of course, people will say that they would rather do both but unfortunately, with trend following, the two things are pretty much mutually exclusive and people definitely seem to have a bias to preferring the frequency of winning over the size of the winnings. Traders therefore suffer from the temptation to take small profits when they have them and let losing trades run in the hope they will turn around, this style of trading appeals to humans emotionally but it is the opposite of long-term trend following and it usually leads to losses, especially on the Forex market.
Another psychological reason for the temptation to take a small profit the moment it appears and let a losing trade get worse is that us humans suffer from what I would call a 'bias for the present moment'. People prefer to have a good thing now over a promise that they will have even more in the future if they will only wait. In trading, this mentality leads to a feeling that this particular trade needs to be a winner. Traders say that they accept that losses will occur and are simply part of the course but that doesn't stop them feeling that while losing trades will happen and need to be accepted this particular trade that is open right now needs to be one of the winners.
One other point about the psychology of trading that I think is often over looked is that most of the time the market seems to do whatever it takes to make most of the market participants wrong. New traders who aren't strictly following a strategy or trading plan often get the feeling that the market is out to get them because whatever position they take the market seems to do the opposite. I believe this is because trades can only happen when there are both buyers and sellers. Every buyer needs someone willing to sell and every seller needs a buyer. In order for a trend to continue the large traders who move the market must continue to place their bets on the trend continuing and drive the trend along; but in order for them place those trades the market must deceive other (usually smaller) traders into taking the other side of those trades. As a general rule small traders and commercial hedgers are duped into taking the other side of the large traders and financial institutions trades.
But of course the market isn't actually out to get anyone personally; it is just naturally doing whatever it takes to find a buyer for every seller and a seller for every buyer and as a general rule most small traders will end up on the wrong side of the trend. And because it is usually the large traders and financial institutions that move the market, most small traders are usually wrong.
For those who are interested in Forex trading I would strongly recommend that they start trading with a demo account and don't start trading with real money until they can stay profitable with a demo account for a long-time. If you cannot succeed at demo trading when there is no real money on the line then you won't be able to succeed when you are trading with your own money and your emotions kick in.
Good luck.
David.
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