We traders often dream that trading would be as simple as learning a ‘winning’ system, that once learned, will give us entry to the land of eternal sunshine and plenty.
But the key to successful trading in the long-term is more complex than just a good system and depends perhaps to a larger extent on psychological self-mastery. I would go so far as to say that psychological factors are what make most traders lose and give up on their trading ambitions in the end, rather than a lack of skill.
Today’s article discusses the first key pitfall and 5 tips and solutions how to tackle it. (more will be discussed in future articles)
Trading is a Kind of Psychotherapy
In the urgent heat of our ambitions, the prospect of working with the psyche is an inconvenient part of trading success that we simply would prefer not to face. Admitting to ourselves any kind of weakness or problem does not come easy, especially if we are driven to just aim in a straight line for our intended worldly goals.
It’s worth understanding from the outset that trading psychology is not different or isolated from the psychological challenges we face in other areas of our lives… it is rather that the act of trading is particularly good at highlighting personal issues that would otherwise be less clearly recognized.
So what are some of the pitfalls we traders encounter along the heroic journey toward freedom through trading? And how can we get through them safely without hurting ourselves, our relationships, or our wallets along the way?
In this series of articles I will highlight the prime psychological challenges most traders will have to overcome in order to ensure long-term success.
Pitfall # 1: The perception of risk during trade management…
So much of profitable trading relies on proper trade management. Two challenges that have stood out as particularly critical during my own trading journey are:
- Not closing winning trades too soon which otherwise easily results in ones losses incurred during losing trades to outweigh the profits made during winning ones.
- Not closing down trades too early, just because they look like they are losing, before they have a chance to play out and turn around.
(Although it can be beneficial to intervene in an open trade at times, it should only be done when a very sound analytical reason exists to do so. )
Following ones trade management protocols may seem sensible for most serious traders, but the ease or difficulty we might have implementing our protocols depends on the degree of risk we perceive in the situation.
For example, it could be that we are able to trade well and follow our trade management protocols to the letter while using demo account money or even a small live test account. We feel safe in the knowledge that we are not really in danger of losing anything or only very little. Thus, our subconscious fears are not aroused while we watch the trades play out.
However when we start trading with real money, two important factors come into the equation
1. How big is your trading account? $500, $5000, $25,000, $50,000?
Imagine how different you might feel when taking the same trade setup with $1000 at risk compared to $50 at risk, even if both amounts are still just 2% the trade account balance (one account having a balance of $50,000, while the other $2500)
- Will it feel different to see an open trade being $500 in minus vs $25 in minus?
- Will you feel more tempted to cut the trade short instead of trusting in your original decision and trade management protocols?
- What will it feel like when a trade is $500 in profit compared with just $25 in profit?
- Would you feel more tempted to cut the trade short and just take the $500 profit instead of allowing the trade to run to its full target beyond a 1:1 reward-to-risk ratio that is necessary to ensure long-term profitability?
- Will you feel more anxious about potentially losing that $500 again if you let the trade continue to run to its target when compared to the idea of just losing out on $25 profit? The answers are most likely yes
2. How much of your total capital is in your trading account? 5%, 25%, 50%, 75%, 85%?
Even if a person is not trading with a large account size, the psychological challenges can be just as big, depending on how much of one’s total savings are invested in the trade account. If we are trading with a large part of our savings, then the psychological challenges may be greater.
For example if your total cash savings amount to $10,000 and you decide to deposit $7500 of this into a trading account in order to try and make an extra small income stream from it, you are essentially trading with 75% of your savings. Yes, you may have a clear rule you follow to only ever risk 2% per trade, but regardless of this, your subconscious will know that even losing $50 in a trade is a reasonable part of those cherished savings. The point being that we will operate differently when we feel safe from when we feel our security is threatened, and our perception of safety will be influenced by how much of our total savings are at risk.
- What will it feel like if you happen to end up with a temporary drawdown of 15%? That would be over 11% of your entire savings… will you panic and continue to interfere in both winning and losing trades because you are terrified of losing more money or would you keep a cool and steady head?
The obvious way to circumvent these issues would be to only trade with a very small portion of ones total savings and risk a very small amount per trade; we would most likely have an easier time if, from a total of $1,000,000 worth of savings, we only use 10% in a trade account and risk 0.5% of that 10% per trade, thereby making it only a 0.05% risk of ones total capital per trade.
However the truth for most people, assuming they have more moderate finances at their disposal, is that risking such small percentages of ones entire capital would mean trading with extremely small lot sizes, which in the longer term will likely feel frustrating and not financially rewarding enough relative to the amount of time invested in the trading process.
So for the majority of retail traders who want to earn some decent supplementary (or complete) income, trading will involve having to master fears when we start to get serious about it.
So how can we help ourselves…?
Tip 1: incremental steps
If you have time on your side, a great way to overcome trade management fears is by starting with a smaller risk per trade that is not going to trigger you into feeling overly exposed and vulnerable during a trade, even if this initially means trading with quite small lot sizes. Once you have shown yourself that you can emotionally cope with going through the cycles of ups and downs during open trades at that level of risk, you are probably ready to increase the risk. If you do this process slowly and steadily in alignment with your increasing confidence and experience of market behavior, you will be able to increase your risk at an emotionally manageable pace and be able to stick to your trade management protocols and enjoy the process more.
Tip 2: Self-analysis and talking to somebody you trust
It’s absolutely essential to cultivate an objective awareness of what is going on for you emotionally while you are trading. If you notice that you are interfering with your open trades too much or make decisions that are reactionary and impulsive, you have to step back enough to recognize what thoughts and emotions are driving you to those detrimental actions. Try to do some psychological analysis on yourself, perhaps by writing about it, or speaking it out loud to your self. Alternatively it can be extremely helpful to have a person to talk to about what you are going through. Often we can only reach enough awareness of what is going in ourselves with the help of another person, and it must be a person you trust and who is neutrally supportive of your choice to become a trader.
Either way, you have to identify the thoughts and emotions that are undermining your trading during certain situations. It is only when you consciously recognize enough what is going on for you that you have a chance to counter-balance those reactionary impulses with sound conscious choices.
Once you know your weaknesses, you need to try and create reference protocols that act as reminders of how to respond when certain emotional fears arise.
Tip 3: Choosing the right stop loss level
I have found that setting my original stop loss appropriately is very important for managing fear during trades. By that I mean to thoroughly analyze the setup you are thinking of entering and identify where a definitive invalidation level is located, i.e. a price level where there would be no more doubt that the original analysis was wrong. Next, check to see if the trade target would still achieve at least a 1:1 reward to risk ratio if you were to place the stop loss at the identified invalidation level. If it were less than 1:1, the setup would not be good enough for me to enter, so it’s best to skip it.
If the original stop loss is set too tight, in the hope of achieving a stronger reward to risk ratio (and therefore more profit quickly), you will know in the back of your mind that price could retrace further back than your stop loss setting, which will increase the likelihood of you interfering with the open trade, especially if you see it going into minus.
You have to set the stop loss at a level that allows you to feel trust and confidence in your decision. That’s how you achieve a psychological advantage.
Tip 4: Don’t overtrade
It is often tempting to take more trades than necessary because we believe that we could miss out on good profits. Having too many open trades, especially if they are strongly correlated currency pairs, can easily make you feel overexposed when they go into minus, which creates another reason why you might start to interfere with the open trades prematurely and cause unnecessary losses… I have done this many times!
Tip 5: Let go of your money!
Before entering a trade setup, I have found it helpful to ask myself the following question: “Am I willing to say good bye to the money I am risking on this trade?”. If you don’t let go of the money you are risking (at least in principle), you are not going to allow the trade to flow. Asking yourself this question can also be a useful way of gauging whether you are really feel confident about the trade setup you want to enter. If you have legitimate doubts about it, you are not going to be able to truthfully answer this question with a yes, which is a good thing because you can use it to filter out setups that are more based on hope and greed instead of sound analysis.
All the best on your journey, fellow traders
Hubert is a trader who uses wave patterns and the ecs.SWAT method. He is also doing analysis and articles for the EliteCurrenSea.com website.