In the end, your performance as a forex trader will depend on your ability to make decisions. To put yourself in the best possible position, it’s probably a good idea to get up to speed on all the different factors which can influence your decision-making; in other words, your psychology.
When you prepare a forex trading strategy, after carrying out your fundamental and technical analysis, it might not occur to everyone that it’s also important to consider your own state of mind and behaviour; your emotions, excitements, and fears. When we get bogged down in the details of our analysis and execution, it can get difficult to keep track of our own reason.
These hard to define factors have a big impact on overall performance, and one of the most common mistakes for new traders is to overlook the importance of the various market mind games traders fall into. By preparing yourself with information about biases and behavioural finance and keeping this awareness when you are making decisions under pressure, you can improve your chances of not falling into the various emotional traps which lurk in wait for the inexperienced.
What is behavioural finance?
You may have heard of the ‘efficient market hypothesis’; the theory that all publicly traded assets with high trading volumes, particularly forex, have fully ‘priced in’ all available information.
In other words, the price of every asset is exactly as it should be, at that time. Under this model, consistently profitably trading is impossible unless you have access to non-public information. This model is loved by academic financiers and price modellers because of the grace and simplicity it gives their calculations, but hated by traders.
For many years, traders who turned a profit were viewed with suspicion by academic finance. In the 1990s it was common to claim the outsized returns of various hedge funds and investment banks were simply down to the size of their balance sheet – or in the case of equity traders, insider trading and even improper dealings with the financial press.
Needless to say, not everyone agreed with this. A new field, behavioural finance, began to gather steam at the same time.
Behavioural finance is a cross-disciplinary research area involving both psychology and finance. Behavioural finance claims that we do not normally, or even usually, make rational financial decisions, and this explains the inefficiency of markets and the possibility of consistent profits.
But how does this relate to trading performance?
Instead, advocates of behavioural finance argue that people use heuristics – simple rules of thumb – to make quick decisions, especially in stressful situations. This can be useful, but can also lead to heuristic bias, where a particular rule begins to dominate your trading pattern in a way that is ultimately counterproductive.
Various effects described by behavioural finance, such as trend following and reversion, can explain why technical trading strategies are profitable.
For example, the fear of missing out on gains often leads traders to rush into an up-trending currency pair, even one that is over-valued, a habit which can be traded profitably by both mean reversion and trend following strategies. But only if you get your timing right.
How our trading psychology leads to biases
Biases are patterns in our behaviour that can lead us to make poor decisions. There are various biases relevant to the psychology of trading; under confidence, when a trader has an excessive fear of losses; overconfidence, which is its opposite; and regret, a sentimental attachment to failed (or sometimes successful) trades.
We have predictable emotional responses that lead us to make all of these errors. Some traders have a solution: they use fully automated strategies, with trading robots. This removes the influence of trading psychology, but other traders argue it also removes a valuable oversight over specific trades and reduces your ability to make adjustments when necessary.
Whether you decide to go with a manual or automatic strategy, it’s good to have a way of checking how your emotions and biases could be influencing your trading patterns. If they are, and if you find yourself often making bad trading decisions under pressure – don’t panic. There are fortunately lots of things you can do to help.
How can you manage your emotions while trading
There are several steps you can take to assess how your trading psychology is impacting you:
- Avoid making deals on the spur of the moment; instead, always consider how a trade fits into your overall strategy
- Assess your own emotions before trading; your mood may influence you to deviate from your strategy
- Be prepared to take a break if you find yourself making poor decisions
- Take care of your health
By consciously stopping and thinking before placing a trade, you can minimise your chances of losing money in forex.
Heuristic bias is often unavoidable; we make decisions in a certain way automatically and without thinking. Fortunately, you can review your past actions, and if you think there might be irrational factors behind particular deals, learn from it going forward.
Market mind games
Trading is an unfamiliar activity to most people and puts us outside of our comfort zone. Even very experienced traders can find themselves overwhelmed, confused, or lost in a particular idea to the detriment of everything else.
If you find yourself focusing incessantly on one strategy, pair, or technical indicator, you might be ignoring other opportunities. It is important to be convinced by your own ideas and research them as thoroughly as possible, but this can blur into a sentimental attachment to particular ideas which is often wrong.
Another version of the same mind game is when a trader consistently repeats the same successful trade in hope of a repeat; if your trade strategy was excellent this might be wise, but sometimes we can wrong ascribe to our own skill chance events.
Try, so far as possible, to consider each trade as a discrete, solitary event. Remember the adage: ‘past performance is not an indicator of future results.’
Adopting a positive trading psychology
A lot of this article has focused on potential risks from poor mental preparation; it’s equally important to remember how psychology can enhance your trading. If you can balance being self-aware without being nervous, and confident without being self-absorbed, you are well on your way to finding your forex trading both more enjoyable and ultimately more rewarding.
Trading takes practice
To get good at anything, including trading, you will need to spend a large amount of time learning the skill. You are much more likely to do this if you are healthy, feeling positive about your financial decisions, and take setbacks or mistakes as learning opportunities rather than marks of failure.
An important, but usually overlooked, component of becoming a successful trader is to enjoy it; enjoy following and reading about markets, enjoy testing strategies, enjoy discovering new things about yourself and the currencies you trade.
If you find yourself coming back to your forex account stressed or disheartened, working to unrealistic targets, or void of all hope of actually making a profit, you will find it incredibly difficult to put in the required time and effort. Some people might be disciplined enough to work through this, but usually those traders who get the most out of the markets long term are those who enjoy themselves the most.
Participate in social trading
If you are struggling with maintaining this positive attitude, why not speak to other traders in the same position? Social trading is a great way to commiserate, share your successes, and keep developing. Many experienced traders are delighted to share their advice and cautions to new forex traders just starting out – they will keenly remember being in the same position as you.
How Rakuten can help
Whatever stage you are at in your forex journey, from novice to master, you can benefit from testing new strategies in a controlled environment. With that in mind, why not sign up for a free demo account and start placing trades without risking any of your capital?