Table of Contents

Lesson 8: Risk Management

8.4 Psychology of Trading

Having Flexibility in Trading Strategies

A trader should have some general flexibility in his or her approach in building equity depending on his or her successes and failures. Basically, there are several different approaches to sizing a position depending on total equity. There are sophisticated approaches and simple approaches. The simplest way is to use a percent of one's equity, like in the examples from the previous page. If a trader has a winning streak, so trade by trade equity grows, then he or she can increase the size of their positions. It is better to build up equity and to trade within the means of your account instead of over-leveraging (taking too big a position) and losing huge amounts on a bad trade. With each loss the size of the next position decreases and each subsequent trade decreases the overall exposure to risk.

It is well known that markets are changing all the time; therefore a trader will have times when he or she re-evaluates their trading plan depending on market conditions. A trading strategy does not have to be set in stone; the more flexible and robust it is, the better. There is a trap however, as some new traders change their trading plans trade by trade, depending on very short term conditions. This can lead to bad results. If a trader feel the necessity to do so, there is probably something wrong with the very core of his or her trading approach.

To repeat this point, the fundamentals of a trading plan should be robust. That means that a trading plan can withstand changes in market conditions and has some flexibility, but that a trader does not have the need to re-evaluate his or her trading plan on a trade to trade basis.

Psychology of Trading - Mastering Emotions with a Trading Plan

We have already mentioned some aspects that deal with the psychology of trading in this lesson, and its time to expand on that.

The market is governed by four basic human emotions: fear, greed, euphoria and desperation. These emotions and how they play out are shown on the charts. Extreme levels, such as panic selling or a torrid uptrend are associated with those emotions. A trading plan is created to manage a trader’s emotions.

Since all traders are people it is understandable that we will have emotional responses to trades. When the market moves with someone, they may feel happy and if it does not, some people may get mad or depressed. The reason that traders have trading plans is to try and anticipate their actions before they even place a trade. In other words, before each trade a trader should sit down and write the steps he or she will take depending on hypothetical changes in the market. These steps would take into account the potential good and bad scenarios. When a trader is already holding an open position it can be hard to think clearly as to what to do next, as emotions may cloud one’s judgment. When one has predetermined guidelines beforehand - a trading plan - it works as an aid in taking emotions out of trading.

There is a potential threat to one's trading if one is not disciplined and does not follow his or her plan. Many new traders fail because they create a plan but then they don’t follow it, because they are emotional and make exceptions. They think, "just for this trade I'm not going to follow my plan because I know the market is going to change in my favor." This can be a recipe for disaster. A trader should not change his or her plan unless they sit down and re-evaluate their whole trading strategy. If the trader comes up with a better plan, then he or she needs to exercise discipline in sticking to it.
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