​Trading is the Art of Balancing Instinct and Critical Thinking

January 15, 2017 06:45

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Dear Traders,

Do you ever follow your trading instinct and spontaneously enter or exit a trade setup?

If you are like most traders, this habit of impulsive reactions probably happens regularly and often makes you feel unsure about the setup. The entire process could be negative for both your trading account (monetary capital) and your trading psychology (mental capital).

But cheer up, there's some good news too.

We're going to teach you a method of creating synergy between your 'impulsive' and 'deliberate' thinking. Join us now to see how to combine instinct and critical thinking to produce an optimal approach for trading the Forex, CFD and financial markets.

trade forex and cfd

Why impulsive thinking is bad

Many traders tend to take impulsive and quick decisions (type 1 thinking), which often do not end well. For instance, they enter or exit a trade too soon or too late.

Why?

Simply because they fear making a mistake, missing a trade setup/exit, and losing out on pips. The main driver of this fear is in a way price action. The market movement can at times be quick and fierce, which messes around with your discipline and trading plan.

Sudden price movements confirm a trader's internal hunch, which is when a trader sets aside rational thoughts and enters the market on a whim. This loss of control often turns out to be costly.

Later on, traders often realize that their entry was based on an emotional reaction. On top of that, the market always makes up and down price movements, which tend to scare traders and make them doubt their original entry.

This impulsive and quick thinking based on instinct leads to traders seeing other various negative effects, including:

  1. not reviewing trade setups and entering without checking
  2. not using their trading plan
  3. taking quick entries and exits
  4. (re)acting with a negative emotional spiral and trading psychology
  5. revenge trading to compensate previous mistakes
  6. witnessing an account drawdown.

Don't overdo slow thinking

Obviously, the opposite (slow) method of analysing the market could help avoid the pitfalls of impulsive overreaction. The opposite entails deliberate and critical thinking (called type 2 thinking) but this also encounters its own problems and dangers.

Why? There are at least 3 reasons.

  1. The financial markets, especially on lower time frames, evolve quickly. Slow reactions could make traders over hesitate with execution.
  2. Critical thinking can also lead to inaction, which is something I regularly run into after completing my wave analysis. This is the main reason why I use waves for trend direction purposes but rely on candlesticks, Fibonacci and trend lines for actual trading decisions.
  3. Another problem traders face is so-called paralysis of analysis, which occurs when traders add too many tools and indicators on the chart. Their decision making is slowed down or blocked due to the overload of information headed their way.

Don't worry, there is a solution

The main question is, can traders balance both quick and deliberate thinking to find a balanced approach?

The short answer is yes, and there two different ways to combine both. Here's the first solution:

  1. Think slow. I want to slow down my thinking to critically review my trade plan and understand each chart in depth (critical approach).
  2. Think quick. Once the plan of is ready, I also need to make sure that I execute my trading plan with quick reactions and no hesitation (impulsive approach). This is only valid after I receive a green light for the first step.

I also use the two thinking types in the opposite way, which is my second solution and it goes like this.

Sometimes an impulsive thought pops up in my mind when scanning and watching the charts. This is a gut feeling that is probably based both on emotions and pattern recognition skills, which have been developed by reviewing and studying the charts regularly.

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Source: various financial instruments with MT4 SE chart

When this happens, I try to flip the thinking approach:

  1. Think quick. Use the impulsive thinking to scan the charts and save time.
  2. Think slow. Use the critical thinking to check whether your impulsive reaction was correct or whether it missed an important overlooked factor.

Quick analysis and scanning followed by a sharp and thorough double check of my initial idea helps me counterbalance my impulsiveness. This process also saves me time. Plus the slow and deliberate approach could also lead to analytical fatigue.

Just make sure to critically examine any spontaneous trade idea (especially a beginning trader should triple check), to review your trading plan, and to check filters before committing to an entry or exit. Always play your own devil's advocate (or ask a trading buddy).

The solution, therefore, is quite simple: combine both thinking approaches.

In my view, traders need to switch gears regularly—from critical thinking to action, and from action to critical thinking at the right time depending on the situation (see above). Plan the trade and trade the plan is a cliche but there is a strong universal truth in it.

Using both thinking styles is a major benefit compared to using only one approach (impulsive is quick but risky; slow is thorough but tiring). Also note that the more experience you build, the better your impulsive thinking will become.

As long as you learn from each trade, assess your losing and winning trades, and use the feedback from the market regularly for improving your trade plan and execution, you will steadily feel more confident in your trading approach.

If you'd like to learn more, please check out our dedicated section on technical analysis. It's being constantly added to, so you'll always have access to the most practical, up-to-date information.

Cheers and safe trading,

Chris

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