The general idea behind market psychology is that market behavior tends to repeat itself around specific financial events and therefore can be predicted via technical indicators.
KEY TAKEAWAYS
- A trader’s psychology is important because it directly impacts the decision-making process, performance, and overall success of the individual or entity in the financial markets.
- Cognitive biases and emotional biases impact a trader’s decision-making process and leads to suboptimal outcomes. These include confirmation bias, illusion of control bias, loss aversion bias and overconfidence bias.
- Traders can overcome their cognitive biases through education and awareness, objective research and analysis and through seeking contrarian perspectives.
- Traders can mitigate emotional biases by being be self aware, establishing trading rules and sticking to them, implementing risk management techniques, and seeking accountability and support from their peers and mentors.
Personal behavior or each trader individually cannot be represented in graphs; however the behavior of bunch of traders all together can be in some way analyzed and concluded in reaction to several economic highlights based on historical movements in the past using indicators and oscillators.
The most common oscillators used by forex traders are MACD, RSI and Stochastics. The mentioned indicators help to figure out the psychological state of mind of the market, by calculating and showing the constant interaction between buyers and sellers in forex market. The oscillators are made of mathematical formulas in order to show market signals which react to overbuying or overselling signs.
Behavioral psychology of forex market goes back to The Theory of Moral Sentiments with two important concepts:
People usually behave irrationally during important decision making
The way a decision is put to a person can influence that decision
In other more comprehensive words, the market is rather unpredictable because you cannot summarize human decision making process into mathematical equation. The more you analyze the market, the more it becomes clear that most decisions in financial markets are arbitrary and irrational!
Overconfidence Bias
Lesson number one on gaining an edge in Forex trading psychology is to watch out for trading euphoria. Humans are naturally self-focused. Our egos want to be validated by proving that we know what we are doing, and that we are better than the average person. Any hint that confirms these thoughts only reinforces our self-image by a distinct feeling of self-love.
In trading psychology in Forex, the problem is that this is where traders are most likely to succumb to overconfidence bias. It’s not uncommon for traders to complete a winning streak and then believe that they can’t get anything wrong in the future.
To believe this is, of course, unwise, and is only going to end in failure. Make sure you always analyse your trading sessions and look at your wins and losses in detail. Reviewing your trades in an honest way is a key aspect of beating your emotions in Forex psychology.
This is the only way you can really stay on top of your trading. Allow yourself to make mistakes – and don’t make the mistake of being scared to prove yourself wrong – you’ll be in a much better position for it in the long run.
A good habit to form for your Forex trading psychology is learning to be comfortable with accepting that mistakes are inevitable, especially in the early stages. It’s all part of the learning curve and the development of your trading psychology in Forex.
Let’s go over some of the psychological characteristics of traders’ behavior. Among others, consider the following features ruling the market:
Reaction to gain can turn into overconfidence and believe in luck
Reaction to losses can trigger higher risk taking
Disappointment after bad decision can lead to fear and avoidance to open new trading positions
Greed can create overtrading
Fixation on amount of possible profits instead of focus on making logical trading decisions
Together with fundamental analysis which shows the “why” of the market behavior, technical analysis allows you to analyze a collective data in order to predict the future market movements.
Like it or not, there are visible and usable patterns in foreign currency behavior, which do repeat themselves. This proves that even irrationality of human traders involved in the market can be used to predict certain future outcomes of the market performance.
Most of us perceive ourselves as rational decision makers; few of us are actually constant and predictable. This is because instead of focusing on each event separately, perceptions are often influenced by the outside factors.
Take for example, the process of buying a car. The car is supposed to take you from place A to place B with a certain level of comfort. Most of us, however allow the car of our neighbors, friends and TV advertisements influence our opinion and need.
Fear
Fear is another overwhelming feeling, completely natural for each living creature, but unwelcome in a traders mindset. Fear can cause you to miss on profits by exiting a winning position earlier, miss on opportunities by not entering a position at all or induce losses when you exit a losing position too early and not give it a chance to turn profitable like your sound trading strategy had predicted.
Like animals, people feel fear as they encounter a source of threat, in our case the threat of losing money. Fear itself has a destructive power over your trading capital, but allowing it to get the best of you will then lead to further negative emotions such as anger, revenge and hatred. Overcoming fear requires a lot of practice, discipline and a lot of thinking beforehand.
Fear very often arises after a long series of losses and especially after having to swallow a loss larger than what you can emotionally absorb. By pondering before entering a trade and knowing how he instinctively reacts to stressful situations, a trader can learn to isolate the feeling of fear during the trading session and move past it.
As mentioned, a market player might be afraid to hold a position open due to fear of losing money. In many cases an unexperienced trader will exit a winning trade too early, due to fear of getting blown out by a price reversal. This is quite the opposite of greed and needs to be battled the same way – by relying on your solidly-tested trading strategy. This includes placing proper protective stops and price targets before you enter the position, ensuring that your trade plan will not be affected by newly arisen emotions during the trade.
The other two types of losses fear can incur – missing on opportunities by not entering a position at all or inducing losses when you exit a losing position too early, are based on the same principle and combated the same way – by trying to remain neutral and sticking to your previously determined strategy. One of the most efficient ways to overcome fear is to never risk an amount of money greater than what you are willing to lose on a cool head. If you have no problem with losing lets say 20 dollars and you risk only that amount, then you should, at least in general, remain calm during the session no matter what happens.
Revenge
As mentioned above, revenge very often follows fear and the negative results it carries with it. For example, a trader might get agitated on missing a very good entry opportunity after having thought about it but decided not to enter due to fear of losing money.
“Revenge trading” commonly occurs after a trader experiences a loss, especially if its greater than what he could usually handle. This once again calls out for using a proper money management system.
Many market players commonly enter revenge mode after a trade, which they were sure will be successful, goes wrong causing the loss of money. There are two things to be considered here: 1. there is nothing sure on the markets; 2. protective stops are your friend.
As they get agitated, inexperienced traders will try to make up for the scored losses by jumping straight back in the market. However, because the decisions they are about to make will be based on emotions, its very likely that they will fail and probably lead to a greater loss than the previous one. Revenge can be associated with overconfidence, which stems from pride.
If all around you drive the latest Land Rover, would you be comfortable with Peugeot 107 (which you can actually afford) or would you take a loan from the bank to be just everyone else in order to fit in? Every single day we buy things we want instead of things we need. Do you really think that it is any different in currency trading arena?
Final Thoughts
In terms of Forex psychology, there is one key piece of advice traders can draw from studying Forex trading psychology – that is to develop a trading plan and stick to it. As a trader in doubt, you should absolutely feel free to research every other possible remedy available, but the chances are that you will still come back to a simple trading plan. It’s understandable for traders to feel fear when they are trading.
However, in Forex psychology, being able to push this fear aside and work through it is absolutely vital for forex traders who want to be successful. Practice trading, make notes, research new strategies and make mistakes.
Trial and error is a massive part of the Forex learning curve and generations of traders have proven that this is the most effective way to eliminate trading fears.
You might want to consider the following quote regarding Forex trading psychology as a point of reference if you start doubting yourself:
Dr. Alexander Elder, in one of his lectures, spoke about a story of an old friend of his, a private trader who was inconsistent and experienced periods of wins and losses alike.
In a couple of years this trader’s name ended up on the US list of top money managers.
When Elder asked ”How, what changed?”, the trader said, ”I am using the same trading strategy that I always have”. ”What changed is that I stopped trading against myself and my strategy”.
That money manager decided to stick to the fundamentals of Forex trading psychology and pulled a mental trick on himself.
When he was still a private trader and was inconsistently profitable, he pretended that he was employed by an investment firm and had a real boss, who gave him a trading strategy and left for a year, leaving the man in charge with one condition.
Upon the boss’s return, the performance of the trader will be not judged by how much money he made, but by how meticulously he followed the strategy.
In other words, he split his trading into two separate roles – the planner, who had no exposure to the market, and the executor, who had no say in planning.
The opposite of fear and greed is a carefree state of mind, and you reach that by mentally defining the risk out of the trade – Mark Douglas.
