20 November 2023

The Psychology of Forex Trading: Mastering Emotions and Decision-Making

Education

In forex trading, psychology refers to the mental states or emotions that influence trading decisions. Trading psychology views traders’ behaviour as a product of psychological factors that can lead to impulsive decisions, biased thinking, and indiscipline. Traders should guard against their psychological biases as it is so influential to their success.

In this blog, you will learn the psychological aspects of forex trading and how to turn various emotions in your favor. In a nutshell, you will learn:

How psychological aspects affect forex trading
The emotional challenges faced by forex traders
How you can master trading psychology and turn the biases in your favour.

Identifying Psychological Biases

Psychological biases impact traders’ ability to interpret forex markets and make appropriate trading decisions. Identifying these biases is the first step towards managing them and building a successful trading career. So, which biases should you guard against when trading forex?

Common Biases in Forex Trading

Two of the most common biases in forex trading are overconfidence and risk aversion.

Overconfidence Bias
Developing a confident trading mindset is key to success in forex markets. However, you need the right confidence as more or less of it can affect your trading decisions.
Think of overconfidence as a situation whereby you have developed a winning strategy and executed it precisely. Over time, your confidence grows, and you feel like you can beat the market by taking more trades, even if they do not fit your trading plan.
As you deviate from the trading plan, you will likely violate the discipline you have developed, including the risk management strategies. Overconfidence may also trick you into making rushed decisions or taking high-risk bets that expose you to significant losses.
Professional traders understand the value of following through a disciplined trading plan. They know there is no reason to take a trade that does not fit their predefined criteria.
As a trader, understand that forex trading is never a sprint. It is a meticulous process that involves keeping track of emotions and avoiding impulsive decisions. When overconfidence sets in, you should reflect and turn to your forex basics of risk management, trading plan, and trading psychology to stay in the game longer.
Loss Aversion
In conventional finance, most investors are risk averse and will shun an investment if it presents a considerable risk than they are prepared to bear. The same can be said in forex trading. It simply means traders hate losing more than they would enjoy their wins.
Risk aversion can be a good thing for forex traders as it helps them enter trades with a higher magnitude of success and lower risks. However, risk aversion, if not controlled, can derail a trader’s journey.
Risk-averse traders tend to pull out of trades after a small profit as they fear they may lose the winners quickly. They miss an opportunity to capitalize on winners for higher gains.
Another common tendency for risk-averse traders is cutting on losses early rather than allowing the trade to play out. The traders may incur losses on trades that eventually turn out in their favour. The irrational decision can arise from the psychological bias of risk aversion or lack of belief in one’s trading system.

The Impact on Trading Decisions

Psychological biases can make a difference between successful and failing traders. Below is a great real-life hypothetical scenario of how psychological biases affect traders. Let's call the traders Effey, Joy, and Keith.

Scenario 1: Effey has made 20 pips on a EUR/USD trade but believes that given their trade setup, his take profit will be hit at 100 pips. Because Effey is risk-averse and fears the trade may reverse direction, he decides to close it at 20 pips profit. The trade proceeds to hit the 100 pip target.
Scenario 2: Joy enters a EUR/USD short trade and, with a $200 drawdown, closes it for fear of further losses. The trade reverses in her direction and hits a level she set as her take profit.
Scenario 3: Keith never lost a trade in September. He believes he is competent enough and can make more money by entering more trades. He deviates from his trading plan, which restricts him to a few trades that fit his entry criteria, incurring losses.

In scenario 1, Effey missed an opportunity to make 100 pips because he is risk averse. Premature closing of trades prevents traders from capitalizing on good trades with better reward-to-risk ratios. This is a bad way to trade, as losses can be greater than wins, making Effey seem an incompetent trader.

In scenario 2, Joy prematurely closes a trade that eventually reaches her profit target and incurs a loss. The moral of the scenario is that traders' emotions can cripple their good market analysis and insights and prevent them from making gains. Yet, forex markets ebb and flow before eventually taking a projected directional movement.

In scenario 3, Keith has developed an overconfident mindset. He already has a winning strategy, but deviating from it because of overconfidence increases his losses.

The above scenarios are classic instances of harmful psychological biases. Luckily, you can avoid the psychological pitfalls and biases by implementing these five best practices:

Build and stick to your trading plan: A trading plan is your tool for strategic decision-making in forex. It dictates the rules for entering and exiting trades, managing risks, and a personalized approach to managing positions.
Challenge your trade ideas: Do you often find yourself closing trades prematurely? It could be time you evaluate your trading ideas. Consider the justifiable factors that warrant a trade closure and stick to it. If you find yourself endearing for a trade for the sake of it, turn to your trading plan.
Monitor your emotions: The way to stay clear of psychological biases is to keep your emotions at bay. Self-dialogue and meditation are some of the ways you can overcome harmful emotions.
Maintain a trading journal: A trading journal is a vital tool for maintaining discipline when trading forex. You can use the journal to keep the specifics of each trade and psychological states when you can or shouldn't take a trade. Reviewing the journal can reveal past mistakes, which you should guard against in the future.
Join a trading community: You might realize that your psychological biases are unknown to you, yet they adversely affect your trade decisions. Having a supportive community can help challenge these psychological biases as you learn from others.

Strategies to Overcome Emotional Challenges

As a forex trader, you have to openly acknowledge feelings of being overwhelmed, anxious, or angry over your trading decisions. That way, you can work towards building the mental discipline you need to become a successful trader. But how do you achieve this?

Developing Mental Discipline

Mental discipline is the mental framework that keeps you motivated and focused. Here are simple techniques you can apply:

Practice as much as possible: Use a risk-free demo account to practice and reflect on your emotional trading journey.
Write down every trade you take, the instrument, position size, take profit, stop loss, market conditions, and why you took it. This way, you can learn good habits and replicate them in everyday trading.
Continually educate yourself about the emotional biases in forex trading: A blog like this is there to help you become psychologically sound to achieve trade success.
Seek advice: Fellow traders, financial advisors, or mentors who have walked a similar journey are good sources of information. You can learn how they navigated the challenging landscape of emotional biases in forex trading.
Reflect on your Forex 101: It is never too late to revisit your Forex basics on emotional biases in forex trading. They will help you refocus and restrategize.
Practicing mindfulness and meditation: If the forex journey gets too lonely, practice deep breathing to reflect as you allow your psychological states to align. Engage your mental faculties on why you are making the same emotional mistakes repeatedly and find answers.
Breaks help: Take breaks from the trade charts for a day or week to reflect on your journey. Breaks can break harmful emotional patterns and allow you to reflect on your forex journey and make adjustments.

Creating a Robust Trading Plan

A trading plan is arguably the most important tool for forex traders. Traders use the plan to dictate the rules, dos and don'ts for their trading decisions. Without it, you are like a directionless sailor on a self-destruction mission on the seafloor.

As an example, you can include the following in your trading plan:

The risk tolerance: For example, never risk 2% of my trading capital.
The currency pairs to trade: You can decide never to trade correlated currency pairs, which presents a double risk.
The leverage level that is commensurate with risk tolerance.
To trade or not trade during major market news such as non-farm payroll data, interest rate decisions, etc.
When to close a trade: You can set it as a requirement never to exit a trade unless it violates an initial setup, major news invalidates the prediction, etc.
Your risk-reward ratio. Most preferably, traders will go for a 1:3 risk-reward ratio. The higher reward compensates for inevitable lost trades, keeping you profitable.

As you discover above, a trading plan is personalized and never the same for each trader. When setting one, a trader should be mindful of their risk tolerance and trading motivation.

In creating a trading plan, you should always have a goal in mind that keeps your eye on the prize. Be realistic, though, and never set an overambitious goal to freak you out and force you into bad decisions.

An example of a good goal: Make a 2% weekly gain and attain a 55% win rate.
An example of a bad goal: To become a billionaire before 30.

You see, the above two goals are ambitious. However, the first is meticulous and attainable. If you were the trader in the first example, you would be happy with a 2% gain as you work your way to make it higher.

The second trader could be forced to make hasty decisions due to the magnitude of the goal. A bad trade could invite anger and revenge, forcing the trader to abandon their trading plan. Losses can be incurred as a result.

Now that you have a trading plan, what next? Adhering to it could be harder than you think. Many traders succumb to fears, emotions, and greed and throw away what is supposed to be a lifesaver when the realities of forex check-in. So, how do you adhere to your trading plan?

Stay disciplined: It is not rocket science; the desire to make more or cut losses will crop up once in a while in your trading journey. If this happens, remind yourself of such self-destructive tendencies. If you must, talk to a fellow trader or move away from your trading monitor. If you win the emotional battle, reward yourself for it.
Remind yourself that you can’t always win: Have you ever lost a trade that ticked all your boxes and felt like taking a revenge trade on it? Unfortunately, traders go through this psychological state and could be the epitome of bad forex decisions.
If you feel so, remind yourself that it is not the end of you, and it's a normal market occurrence. Remember that another quality trade will appear under your nose the next time, and you can always recover the lost opportunity.
Be patient: Successful forex trading is a game of patience. You require patience waiting for your trade conditions to be met or a profit target to be hit. If you are not patient, you will end up taking bad trades, trading under unfavourable conditions, or closing positions prematurely.
Revise and improve: A trading plan is intended to be personalized and to serve you in the long term. Suppose you realize it is not realistically serving you. You could consider changing it. Doing so helps you avoid the temptation to deviate and make unpopular decisions.

Exercises to Improve Decision-Making

Not every good trade has a chance of becoming a success. As such, it would be best to have a precise trigger that tells you it is now time to enter a trade. You also need to reflect and learn from losing positions.

Scenario analysis, journaling, and learning from trades can help when you have to make such forex decisions.

Scenario Analysis

In scenario analysis, traders estimate the expected outcome of a trade, assuming a specific set of conditions. Visualizing different trade outcomes can help a trader make a better decision or decide whether to wait a little longer before taking a trade. Let’s do this with an example:

Assume you have been monitoring the recent strengths in USD/JPY. The trade reaches a resistance zone, which has previously triggered shorts. Would you take a sell trade?

The answer would be a yes or no, depending on the market conditions. However, successful traders understand the importance of trading with confluence. This means they wait until additional factors inform their trade confidence.

As a trader, it would be necessary to wait for a trade action signal before entering a position. Examples of signals to watch out for include a breakout, a reversal, and a bullish or bearish pin bar signal. The signals offer additional clues about trend continuations or reversals.

Also, it is essential to make informed decisions based on data. You can revisit your forex economic calendar, fundamental developments, or sentiments based on analysts to conduct a scenario analysis. You can ask questions like, is the projected rate hike decision good for currency X and vice versa?

Making informed decisions based on data helps traders take positions accordingly, determine their risk exposure, or manage a trade.

Journaling and Reflection

Earlier on, we taught you how important a trade journal is. A journal helps you to record trades and trading decisions and use them to learn and improve. Here is a step-by-step guide to creating your personalized trading journal:

Step 1: Decide the format you want your journal to be. A spreadsheet is recommended as you can benefit from its built-in analytical features.
Step 2: Identify the information you want to record in your trading journal. As a rule of thumb, a trading journal should include the date of trade, the asset, trading strategy position size, profit target, and outcome.
Step 3: Record each trade and make entries for each journal parameter
Step 4: Reflect on the recorded trades on a specified timeframe, say, daily, weekly, monthly, etc.

Conclusion

In a nutshell, forex trading is a journey that involves mastering one's emotions to build a resilient trading psychology. To succeed, investors must overcome false confidence, greed, fear, anger, and revenge. These emotional challenges force forex traders into impulsive decisions that heighten losses.

Traders can overcome psychological and emotional biases by having a robust trading plan and practicing mental discipline through mindfulness and learning from others. Traders should also embrace trade journaling to learn and improve their previous decisions. Conducting scenario analysis can help forex traders enter well-informed trades with greater confluence.

Disclaimer: Any information presented is for general education and informational purposes hence, not intended to be and does not constitute investment or trading or tax advice or recommendation. No opinion given in the material constitutes a recommendation by M4Markets that any particular investment, security, transaction or investment strategy is suitable for any specific person.

It does not take into account your personal circumstances or objectives. Any information relating to past performance of an investment does not necessarily guarantee future performance.

Trinota Markets (Global) Limited does not give warranty as to the accuracy and completeness of this information.

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