In the last part of our forex trading course for beginners, we will discuss trading psychology, a trading system you can use, and what forex brokers you can trade on.
If you haven't read the previous parts of the guide, I recommend you to do so before reading the current article:
- Forex Trading Course for Beginners - Forex Fundamentals [Part 1/4]
- Forex Trading Course for Beginners - Forex Charts & Trends [Part 2/4]
- Forex Trading Course for Beginners - Forex Indicators & Strategies [Part 3/4]
11. Trading Psychology - Greed & Fear
Besides all of the fundamental and technical factors that a trader must keep track of to succeed, another area that is often overlooked is themselves.
No matter how good your strategy is, the other factor which will always influence your outcomes is your own emotions. After all, it is emotions that move the markets.
Emotions are what most of our indicators are designed to give us a measurement of. And to be able to profit from market movements created by the feelings of others, you must first learn how to read the mood behind the move and how to recognize and control your own.
As prices rise, they naturally attract more attention. As more and more people jump on board the rally, its climb accelerates. But in all the excitement, there is a tendency to confuse account balance (the amount actually on your account) with account equity (the total value including the sum of your open positions).
People begin to treat their potential profits as having already realized them. This expectation can sometimes cause essential reversal signals to be overlooked.
Additionally, those who missed out on the opportunity early on, when the trend was still young, are becoming hypnotized by the length and size of the rally. However, jumping onboard late is a risky game, as those who got in early will eventually need to take their profits.
There is also a bit of the "greater fool" factor, as anyone who is still buying is now buying at a higher price, and from a seller who has reason to believe the move may soon be over.
The idea then is that hopefully, someone will keep on buying after you, at an even higher price, when you eventually decide to become a seller yourself.
When prices start falling, they awaken fear and panic. Fear is one of our primal emotions, which explains why prices often fall faster than they rise. People holding longs run for the door trying to sell as quickly as possible, and short-sellers motivated by the falling prices also add their orders to the mix. Temporary rallies can give false hopes when those short orders are eventually covered to realize a profit.
This crowd mentality frequently creates moments of market imbalance which can be capitalized upon once one can learn to recognize the signs and interpret them correctly. Above all else, the key to developing this skill is practice.
How Emotions Manifest on Charts
One of the critical measurements of market sentiment is support and resistance. If resistance breaks, there are more bulls in the market at that time than bears. If it bounces, we know the bears have overpowered the bulls.
Likewise, if a support level holds, we know that any drops in price were most likely caused by normal profit-taking. If it breaks, on the other hand, we know we have short-sellers entering the market along with longs starting to close their positions. Another indicator that mood and sentiment in the market may change is momentum.
Declines in follow-through on moves can often signal a drop in enthusiasm and an increased likelihood of a pending reversal. Both trend-following and oscillating indicators can give us clues and insights, especially as divergences appear on the chart.
Lastly, there is volume. Often overlooked on forex charts due to the lack of a centralized exchange (though still worth paying attention to even if it is only the volume from your broker), the volume should typically increase as trends accelerate in either direction.
If volume suddenly starts to drop off, it can signal an impending end to the trend in question or some turbulent times ahead.
Learning to Control Your Own Emotions
The first step to becoming a more disciplined trader and controlling your emotions is becoming aware of them. If your results are not consistent, take a close look to see if you are indeed following the strategy you outlined for yourself.
Are you entering and exiting positions due to a well-defined signal, or was there another reason?
Here are some of the most common "symptoms" to watch out for, especially if you see the pattern occurring with some regularity:
- Getting out of positions too early, only to see them continue in the direction you hoped, is a sign of fear.
- Staying in positions too long and watching the markets take back some of your profits is often a sign of greed.
- Closing a position for a loss, only to see it reverse and go back above break-even moments later, is a sign of fear.
- Not closing a losing position and letting small losses become larger ones in the hope of a reversal that never comes can often be a sign of greed. After much of it has already happened without you, Jumping into a trend late can stem from a fear of missing out on the move.
- And jumping in too early, before the market's given clear evidence of a direction, can be driven by greed. It is essential to take a step back and closely look at what is going us into and out of the markets. Is it the strategy and signals we have outlined for ourselves (which should be easy to verify), or is it something else?
Our progress in the markets can only be as good as the records we keep and the time we spend reviewing them.
When we hear the news in the markets, it is essential to do a quick reality check to make sure we're giving both positive and negative news the same weight in our evaluations and not allowing our biases towards a position to interfere.
The absolute best time to set both targets and stops is before entering the position. Once the hopes and stresses of the market become your own, we can rely less and less on clear and sound judgment.
12. Money Management and Building Your Trading System
The final and by far one of the most critical factors to your success is money management (sometimes also referred to as position-sizing). To illustrate just how important it is to your final results, a mathematical study confirms that even completely random entries, based upon a coin toss and yielding only a 35% "win" ratio, can produce steady profits when combined with proper money management formulas.
To break it down by level of importance and influence, Experts can say that money management accounts for up to 50% of the final result.
Approximately 40% can be attributed to psychology 8% to exits (including targets, stops, and position management), which leaves 2% for entries. And, yet, when most people believe they have a system, what they mean is they have a set of signals for entry.
The Components of a Good System Every
Every system should include the following components:
- Criteria for entering trades
- Indicators to confirm entry signals
- Criteria for exiting trades (or staying in them)
- Rules for setting stops
- Rules for setting targets
- A method to size positions relative to risk
A way to look back and evaluate trades
A Simple Money Management Formula A good rule of thumb for sizing positions is to risk 2% of your account equity in any one position. That's 2% assuming the worst-case scenario of a stop loss being triggered.
Therefore it should be easy to calculate how much is being risked based upon the total size of the account and the distance in pips to the stop you have in mind for any given position. If you are trading a strategy that requires you to use wider stops to be effective, you will have to consider using smaller lots. Conversely, if you find yourself trading with smaller amounts than you like, you will have to seek a strategy that uses tighter stops (and, therefore, closer targets and perhaps smaller timeframes).
It is far better to make small yet consistent profits than having one or two big wins, followed by an equally significant loss that creates irreparable damage to your account. By far, the biggest mistakes made by new traders are over-trading (due to greed and fear – see lesson 9) and trading with positions too large relative to their account size.
Keep in mind that larger positions are also more uncomfortable if the market moves against you, making it that much more likely to exit early, not giving the markets enough time to move in your favor. You should also note that 2% is the maximum… for positions you feel strongly about. It is also quite acceptable (and recommended) to useless. Additionally, there should never be more than 6% of your account balance exposed at any one time as a sum of all open positions.
Risk vs. Reward
The other critical factor is a healthy risk-to-reward ratio. What is the distance from your entry price to your stop vs. the distance to your target?
You should avoid trades with a ratio of 1:1. Strive for a minimum ratio of 1:2 (that is, your target distance is twice as big as your stop). This does not mean arbitrarily tightening stops or widening targets – You must still obey the rules of your strategy – it just means passing on trades that do not satisfy this requirement.
Of course, your overall percentage gain improves dramatically once you become good at identifying trades with risk-to-reward ratios of 1:3, 1:5, or even better. When combined with proper money management, these two keys become the final pillar of your trading system.
And there you have it. In the 4 parts of our forex trading for beginners course, you learned almost anything you need to start trading the markets.
What you need now it's to grab some hands-on experience.