How to Improve Your Forex Trading Psychology and Manage Risk

July 07, 2021 17:00 UTC
Reading time: 19 minutes

Trading psychology and risk management are key features in the makeup of a successful forex trader. When trading Forex, commodities or stocks, it is often trading psychology, rather than a lack of academic knowledge or skill in application, that is considered to be the primary originator of mistakes.

Such errors are constantly repeated by financial traders of various backgrounds, which suggests that it is the common traits shared among us as humans that lie at the very heart of those mistakes.

 

How to Improve Your Forex Trading Psychology and Control Risk Management - A Guide

That common trait is fear, which creates the 'fight or flight' response in humans. Unfortunately, it is this fight or flight response which can cause the downfall of many traders. So, how do you manage risk in trading? We cannot change what we have evolved to feel over millions of years, but we can change how we approach and deal with these feelings.

Today, we will learn how to master our Forex trading psychology by looking at tips on how we should behave in response to every day trading situations.

Fear can have a significantly limiting effect on trading behaviour. Naturally, your mind will want to find the safest option to ensure survival. In terms of trading, this means that if a trade looks like it is going to lose profit, your natural instinct would be to pull out of the trade, so that you do not incur further losses.

However, this can steer you away from a carefully planned trading strategy. Even worse, it could cause you to make rash decisions, with the hope of turning that losing trade around, causing you to lose much more money. Instead of focusing on the long term plan, your mind wants to focus on making the best out of this short term losing position.

Understanding the role of Forex trading psychology will help you to alleviate fear from your decision-making process and help with your risk management. Becoming aware of fear on the spot will empower you, both as a trader and as an individual. It will also allow you to re-establish the control of logic and reason, which is your ultimate goal.

Types of Trading Bias - An Overview

It's easy for traders to feel confident in their ability to remain calm and collected during their trading sessions before the market opens. However, once the clock starts it's a different story. When faced with real financial decisions, it's very easy for emotions to come into play. We can't avoid our emotions, but we can learn to work around them.

Traders cannot afford to give in to feelings of excitement, fear, or greed when trading, as it can cause costly and irreversible mistakes. Evaluate yourself psychologically by identifying if you are exposed to one of the following psychological biases of Forex trading:

  • Overconfidence bias - 'The market will go here'
  • Anchoring bias - 'This probably means that'
  • Confirmation bias - 'This also proves that I am right'
  • Loss bias - 'I hope the price will come back'

Notice how they overlap, because no matter how you look at it each of these biases, they all boil down to fear.

So, how can such Forex trade psychology be overcome?

We shall discuss each of these points in detail, because the first key step is to become aware of our emotions.

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Forex Trading Psychology - How to control your emotions

The key aspect of Forex trading psychology involves managing and controlling your emotions. So, how do you beat your emotions in trading? Within Forex trading psychology, the first step is understanding your emotions. Once you understand them, you will be more capable of recognizing unhealthy psychological patterns and states of mind and then react in a way that can protect yourself.

These psychological biases are relevant to trading psychology in Forex and in any market. They are not specific biases that are important only in the psychology of trading Forex, the psychology of trading stocks or the psychology of day trading. A trader who is aware of them will be better protected while trading in any market.

The first bias I cover in this guide on Forex psychology is the overconfidence bias.

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.

Anchoring Bias

The next bias in this Forex trading psychology guide is about mental comfort zones created by traders when performing market analysis, by ultimately thinking that the future will be the same as the present, purely based on the reason that the present appears to be like the past. Just as with other biases in Forex trading psychology, this one is directly borrowed from social studies.

Anchoring is a tendency to rely on what is already known to a trader for decision making in the future, instead of considering new situations and the changes that they can bring. At times, anchoring tends to cause traders to rely on obsolete and irrelevant information, which of course won't help them trade successfully.

In practical terms, this aspect of trading psychology in Forex manifests itself in traders holding losing positions open for too long, simply because they fail to consider the options that are outside of their comfort zone.

In developing your psychology of Forex trading, you must not be afraid of trying new things when trading Forex - be willing to try new strategies, and go against what you know. By anchoring yourself to outdated strategies and knowledge, you're only increasing the probability of bigger losses.

Confirmation Bias

The third bias in this psychology of Forex trading guide is the confirmation bias. It is one factor that is most common amongst professional traders. Looking for information that will support a decision you have made, even if it wasn't the best decision, is simply a way of justifying your actions and strategies.

The problem is that by doing this, you're not actually improving your methods, and you're just going to keep making the same trading mistakes. Unfortunately, this can create an infinite loop in Forex trading psychology that can be difficult to break.

The best-case scenario in confirmation bias is that a trader will simply waste precious time researching what they already knew to be true. However, the worst-case scenario is that not only will they lose time, but also money and the motivation to trade.

In the psychology of Forex trading, a trader must learn to trust themselves, be happy to use their intelligence to develop profitable strategies and then be able to follow them without fear or doubt.

Loss Aversion Bias

The final bias I discuss in this psychology of trading Forex guide is the loss aversion bias. This one derives from the prospect theory. Humans have a funny way of evaluating their gains and losses, along with comparing their perceived meanings against each other.

For example, when considering our options before making a choice, we are more willing to give preference to a lower possible loss over a higher possible reward. Fear is a much more powerful motivator than greed. In practice, a trader with a loss aversion bias is more akin to cutting profits when they are still low, while allowing bigger drawdowns.

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Mastering Forex Trading Psychology

Now we have covered the four key aspects of psychology in Forex trading and trading all other markets. You now know the different types of trading biases and how it is important to take control of our biases to improve our trading performance.

So, how can we beat our emotions? How can we master such trading psychology in Forex? In the free webinar below, Jens Klatt, an experienced trader, shares how you can master your trading biases, understand what behavioural finance is in Forex trading psychology and shares how to establish a daily trading routine.

It's time to look at the other half of protecting yourself while trading: risk management.

What is a risk management system in the stock market, Forex, etc?

Trading risk management is one of the most important aspects of a trading strategy. While traders want to keep losses as small as possible, they also want to earn profits. As such, traders sometimes take big risks, which can result in big losses.

The reason Forex traders often lose money trading isn't always due to a lack of experience or knowledge of the market. It's often because of poor risk management and a weak understanding of trading psychology in Forex. Sound risk management is an absolutely essential aspect of becoming a successful trader.

Below are 5 top Forex risk management tips that can help you reduce your risk in trading. These tips can be useful at all levels of trading, from beginner to professional, and in all areas of Forex trading psychology (and in the psychology of day trading, psychology of trading stocks, etc.):

  • Educate yourself on trading and Forex risk
  • Use stop losses
  • Use take profits to secure profits
  • Don't risk more than you can afford to lose
  • Limit use of leverage

#1 Educate Yourself on Trading and Forex Risk

The first tip in the risk management section of this Forex trading psychology and risk management guide is regarding education.

What is the first rule in trading?

If you're a new trader, the more education you can receive the better. In fact, regardless of your level of trading experience, there is always more to learn and ways to evolve and become a better trader! Continue educating yourself and reading everything trading psychology and risk management related.

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#2 Use Stop Losses

The second tip in this Forex trading psychology and risk management guide is a reminder about using a simple and effective trading tool.

All levels of traders lose money regularly. However, every trader's goal is to ensure that profits are greater than losses when they close their trading session. An effective way of protecting yourself from great losses is with stop losses.

stop loss is a trading tool that can help protect you from sudden market movements by allowing you to decide on a price level at which your position will be automatically closed. Therefore, if you open a trade hoping the price of the asset will rise, but it decreases: when the price hits the level of your stop loss, your trade will be closed, protecting you from incurring further losses if the price were to continue falling.

#3 Use a Take Profit to Secure Profits

This is another useful tool. A take profit is similar to a stop loss. However, as the name implies, it serves an opposite purpose. While a stop loss works to close trades to avoid further losses, a take profit automatically closes trades at a predetermined level to secure profits.

#4 Don't Risk More Than You Can Afford to Lose

One of the key rules in Forex trading psychology and risk management is to never risk more than you can afford to lose. Despite the logic behind it, traders often mistakently break this rule, especially those who are new to trading and unfamiliar with Forex psychology and risk management.

The markets are highly unpredictable, so risking more than you can afford to lose puts you in a vulnerable position.

#5 Limit Use of Leverage

Leverage allows you to magnify your profits on your trades. However, it can magnify your losses to the same degree, which increases your potential for loss. For example, with a 1:30 leverage on an account with $1,000, you can open a trade worth up to $30,000.

In this case, if the price level moves in your favour, you will receive the full benefits of that $30,000 trade, despite only putting $1,000 of your own money into it. However, you can incur the full loss of a $30,000 trade if the market moves against you.

A trader must set rules and follow them the psychological pressure comes. Set guidelines based on your risk tolerance, for when to open a trade and when to close it. Decide on a profit target and have a stop loss in place to remove emotion from the process.

If you want to know:

  • 5 more fundamental tips for risk management
  • What correlation is and how it can help in your Forex trading psychology
  • Key risk management tools you can access today to help minimize your losses immediately

You might be interested in our article, Trading Risk Management: Top 10 Forex Risk Management Tips.

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.

What's more, it worked!

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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.

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