Trading Psychology

Trading psychology is one of the most important areas a trader must understand. Most traders often overlook this crucial area, believing that trading systems are the most important aspect of trading successfully. However, when you think about it, your beliefs about the market can have a significant effect on how you trade.

To illustrate the importance of psychology, the following is a quote from world renowned trading coach Dr Van Tharp:

“When I’ve had discussions about what’s important to trading, three areas typically come up: psychology, money management (i.e., position sizing), and system development. Most people emphasize system development and de-emphasize the other two topics. More sophisticated people suggest that all three aspects are important, but that psychology is the most important (about 60 percent), position sizing is the next most important (about 30 percent), and system development is the least important (about 10 percent).”

When it comes to trading, one of the most neglected subjects are those dealing with trading psychology. The majority of traders spend days, months and even years trying to find the right system to suit them. But having the right trading system is just a small part of what is really needed to trade forex, or any other financial market successfully. Don’t get me wrong, it is still important to find or develop a trading system that suits you, however, it is also important to have a well defined money management plan, as well as an understanding of all the psychological barriers that may affect the trader’s decisions when trading. In order to succeed in the business of trading, there must be a balance between all these important aspects of trading.

In the trading environment, when you lose a trade, the first idea that pops to mind would probably be, “There must be something wrong with my system”, or “I knew it, I shouldn’t have taken this trade” (even when your system signaled it). But sometimes we need to dig a little deeper in order to see the nature of our mistake, and then work on it accordingly. This means looking at the possible psychological biases you may have when it comes to developing and executing a trading system. This is explained in more detail below.

When it comes to trading the Forex market as well as other markets, only 5% of traders achieve the ultimate goal: to be consistent in profits. From my research I believe the main reason for this is a lack of understanding of what a trader should actually be taking into account, which could be largely attributed to their own psychological biases they have toward trading.

Psychological Biases

To best explain how trading psychology isn’t just about positive thinking, here is an example of how your psychological biases can effect your trading.

Consider a new trader that has an interest in trading the forex market. They would most likely believe that a trading system is the place to start, so they go off on the internet and search for keywords such as “forex trading system”, or “trading system”. They would also be likely to want to find a trading system that is very accurate, say around 80% + accuracy. The reason for this? Well from my research I have discovered that this way of thinking has been taught to us at a very young age mostly by the school system. School teaches us to be right 80% + of the time, and if we are not, we are considered a failure. The internet can also be blamed for this. If you were to search for anything trading system related, you would soon be bombarded with advertisements such as “System produces 90% accurate trades” or for those advertisers who are really pushing their luck: “100% wins, 250+ trades, NO losers BUY NOW!” All these advertisements cause you to believe that it is necessary to be right the majority of the time in order to succeed at trading.

Now the problem here is two fold. Firstly, their belief that a trading system is so important is not actually correct. There are other factors that are in fact more important such as, money management and psychology. And secondly there belief that they need a trading system that produces profits a very high percentage of the time is not absolutely correct either.

These are bias’s you have toward trading system development because you do not yet understand what is really involved in developing and implementing a system that actually works over time.

This is where the ‘Mathematics’ of trading system development and implementation come in. To illustrate how you do not necessarily have to have a trading system that wins 80% or more of the time, consider the following:

You have a trading system that is accurate and makes money only 50% of the time. On average you make three times as much as you loose. Let’s say your average win is 60 pips, and your average loss is only 20 pips. The following equation will work out how much you can expect to make on average:

(PW multiplied by average win of 60pips) Minus (PL multiplied by average loss of 20 pips) = 20pips.

Key: PW = the percentage of time you make money, PL is the percentage of the time you loose money.

This means you could expect to make 20 pips on average, even with a win rate of only 50%! Now it is important to keep in mind that the purpose of this article was not to explain the specifics of trading system development, nor the mathematics involved. It was to explain how your own trading psychology can have an effect on the way you trade the financial markets.

Conclusion

By understanding areas such as trading psychology, and money management at an early stage of your trading career, you will be able to develop a system that produces profits consistently, and be up there with the top 5% of traders who actually succeed in trading the financial markets.