Forex Money Management Trading and psychology

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The Importance of Trading Psychology

Containing fear and greed are key to making money

Many skills are required for trading successfully in the financial markets. They include the abilities to evaluate a company’s fundamentals and to determine the direction of a stock’s trend. But neither of these technical skills is as important as the trader’s mindset.

Containing emotion, thinking quickly, and exercising discipline are components of what we might call trading psychology.

There are two main emotions to understand and keep under control: fear and greed.

Snap Decisions

Traders often have to think fast and make quick decisions, darting in and out of stocks on short notice. To accomplish this, they need a certain presence of mind. They also need the discipline to stick with their own trading plans and know when to book profits and losses. Emotions simply can’t get in the way.

Key Takeaways

  • Overall investor sentiment frequently drives market performance in directions that are at odds with the fundamentals.
  • The successful investor controls fear and greed, the two human emotions that drive that sentiment.
  • Understanding this can give you the discipline and objectivity needed to take advantage of others’ emotions.

Understanding Fear

When traders get bad news about a certain stock or about the economy in general, they naturally get scared. They may overreact and feel compelled to liquidate their holdings and sit on the cash, refraining from taking any more risks. If they do, they may avoid certain losses but may also miss out on some gains.

Traders need to understand what fear is: a natural reaction to a perceived threat. In this case, it’s a threat to their profit potential.

Quantifying the fear might help. Traders should consider just what they are afraid of, and why they are afraid of it. But that thinking should occur before the bad news, not in the middle of it.

Fear and greed are the two visceral emotions to keep in control.

By thinking it through ahead of time, traders will know how they perceive events instinctively and react to them, and can move past the emotional response. Of course, this is not easy, but it’s necessary to the health of an investor’s portfolio, not to mention the investor.

Overcoming Greed

There’s an old saying on Wall Street that “pigs get slaughtered.” This refers to the habit greedy investors have of hanging on to a winning position too long to get every last tick upward in price. Sooner or later, the trend reverses and the greedy get caught.

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Greed is not easy to overcome. It’s often based on the instinct to do better, to get just a little more. A trader should learn to recognize this instinct and develop a trading plan based on rational thinking, not whims or instincts.

Setting Rules

A trader needs to create rules and follow them when the psychological crunch comes. Set out guidelines based on your risk-reward tolerance for when to enter a trade and when to exit it. Set a profit target and put a stop loss in place to take emotion out of the process.

In addition, you might decide which specific events, such as a positive or negative earnings release, should trigger a decision to buy or sell a stock.

It’s wise to set limits on the maximum amount you are willing to win or lose in a day. If you hit the profit target, take the money and run. If your losses hit a predetermined number, fold up your tent and go home.

Either way, you’ll live to trade another day.

Conducting Research and Review

Traders need to become experts in the stocks and industries that interest them. Keep on top of the news, educate yourself and, iif possible, go to trading seminars and attend conferences.

Devote as much time as possible to the research process. That means studying charts, speaking with management, reading trade journals, and doing other background work such as macroeconomic analysis or industry analysis.

Knowledge can also help overcome fear.

Stay Flexible

It’s important for traders to remain flexible and consider experimenting from time to time. For example, you might consider using options to mitigate risk. One of the best ways a trader can learn is by experimenting (within reason). The experience may also help reduce emotional influences.

Finally, traders should periodically assess their own performances. In addition to reviewing their returns and individual positions, traders should reflect on how they prepared for a trading session, how up to date they are on the markets, and how they’re progressing in terms of ongoing education. This periodic assessment can help a trader correct mistakes, change bad habits, and enhance overall returns.

What Is Risk Management?

Risk management is one of the most important topics you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses).

Many forex traders are just anxious to get right into trading with no regard for their total account size.

They simply determine how much they can stomach to lose in a single trade and hit the “trade” button.

When you trade without risk management rules, you are in fact gambling.

You are not looking at the long-term return on your investment. Instead, you are only looking for that “jackpot.”

Risk management rules will not only protect you, but they can make you very profitable in the long run. If you don’t believe us, and you think that “gambling” is the way to get rich, then consider this example:

People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win.

The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don’t win.

That is where the term “the house always wins” comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money–not the gamblers.

Even if Joe Schmoe wins a $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON’T win that jackpot and the money will go right back in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses.

Essentially, this is how risk management works. If you learn how to control your losses, you will have a chance at being profitable.

In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser.

You want to be the rich statistician and NOT the gambler because, in the long run, you want to “always be the winner.”

So how do you become this rich statistician instead of a loser? Keep reading!

Forex Money Management: Trading and psychology

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