Before we get under way with this lesson on risk management and trader psychology, it should be pointed out that the information presented here is for educational purposes. The information and techniques presented are for a new trader’s consideration when entering the world of Forex trading. By no means does a trader have to use any of the techniques in this lesson, but it is worth your time to read through it and consider whether it is something you may want to incorporate. The examples and numbers used in the examples are not meant to be used literally; they are picked as an easy way to illustrate how the techniques work. With that in mind, let us begin.
A very important aspect to the psychology of trading is the ability to create and maintain a trading plan. As a famous saying in the market goes, “if you fail to plan, plan to fail.”
Planning is closely linked to the discipline of a trader. Experienced traders know that discipline and a trading methodology are key to long term survival in the financial markets. It’s common for very new traders to make money on demo accounts, but many times these same traders lose when entering the live market because they fail to exercise discipline when real money is involved.
This lesson will outline some principles to creating a trading methodology along with techniques for risk and money management. New traders that jump into trading with their only goal being quick and high returns have a good chance to wind up losing, because they do not focus any energy on long term survival or steady capital growth.
The first step to creating a viable trading plan is to determine what kind of markets a trader is comfortable trading. There are two fundamentally different preferences for entering trades. The choice for a trader is between being a trend following trader, or a counter-trend trader.
Trend following traders are trying to catch relatively long term trends. In the above figure, there is a downward trend in the EUR/USD pair that lasts about two weeks. A trend following trader would enter on a certain technique when he sees the potential for a new relatively long lasting downtrend. In the above example, a trader opens a short position on Oct. 4th, and keeps the position open until there is a "go long" signal on the 15th.
Other traders try to trade consolidations or ranging markets. They do not adhere only to markets that are showing long term trends. Markets can go in three directions: up, down or sideways, and a counter-trend trader prefers to trade the back and forth movements of a sideways market.
In a ranging (sideways) market the counter-trend trader will try and "buy low, sell high" or "sell high and buy low". In the figure above, a trader would short the pair when it reaches certain high levels, and long the pair when it reaches certain low levels. The figure is a rough guideline of course, and a trader has to have a good feel and/or technical analysis to back up his or her prediction about the market’s behavior. A counter-trend trader relies heavily on support and resistance levels and should be prepared to trade against the recent trend if he or she believes there will be a pull back or retraction. Counter-trend traders will also have to be wary of price breakouts and a change to a trending market, which would put counter-trend trades in jeopardy.
Trend following traders are trying to buy the strength of the market while selling its weakness. Counter-trend traders try to “fade” the market by selling the strength and buying the weakness of the market. Of course, a trader could apply both aspects to his or her trading, but for the most part one is more comfortable trading one style over the other. It takes a different trading psychology to be able to place orders against the current trend because one believes there will be a retraction, than to trade a long term uptrend. However, since markets spend one third of their time in sideways trends, one may have to sometimes be a counter-trend trader; the alternative is to sit out and wait until there is another trend. To improve a trading methodology, one must decide what kind of trading style fits him or her, depending on psychology and what kind of market conditions the trader is comfortable trading.
The next step to developing a trading methodology is for a trader to select the tools that he or she will be using for entering and exiting trades. If a trader will be using technical analysis he or she can use trendlines, support and resistance levels, fibonacci levels, and technical indicators. Based on those tools, a trader then creates a trading plan. The plan’s main features are what signals one is looking for in order to enter and exit a trade. A trader using fundamental analysis will also have to come up with a trading plan which would include what economic indicators the trader will be tracking, along with the conditions he or she is looking for in order to enter and exit a trade.
This lesson’s purpose is not to outline what signals to use to create a trading plan; that is up to the individual trader. There are many resources that one could find, including on this website, that give some guidance on using technical and fundamental analysis to create a trading plan.
Once a new trader has laid out some guidelines on how they will enter and exit trades, it is very prudent to trade on a demo to build up experience, before opening a live account. It is important for a plan to be able to weather market moves that are relatively unexpected; therefore a trading approach should factor in market noise. With a demo account, a trader can train oneself psychologically, in exercising discipline and sticking to a trading plan. Once a trader achieves consistent success on a demo then it may be time to move to live trading. There will be a learning curve with live trading compared to demo trading as conditions are slightly different, and since real money is on the line, a trader’s emotions will come into play.