Trading in the financial markets offers some of the greatest risks and rewards imaginable, and it is for this reason that many traders become quickly ruled by emotion. Emotional reactions, however, can be thought of as the anti-thesis of rational thinking and this can make it extremely difficult to make the best decision at any given moment. Here, we will look at some ways of structuring both your trades and your trading mindset so that emotions can become less of a controlling factor in your daily routines.
Problems Created by Emotional Reactions
Of course, as human beings, there is no way for us to completely remove the factor of emotional response from the trading equation but there are ways of limiting the destructive effects that can be seen when non-logical reactions become apparent. Added knowledge is a vital component, as understanding the ways indicators or other charting tools actually measure price activity can bring an added sense of mental comfort as technical analysis trades unfold. But this knowledge will have its limitations as well, as there will be cases where flawless technical analysis can still lead to failing trades.
This can be a difficult thing to accept, and in many cases emotions here can lead traders to stay in a position too long (and encounter unnecessary losses) in the belief that position “must” turn positive later given the strength of the underlying analysis. This is a key example of a situation where emotions can have very harmful effects - even when solid technical analysis methods are implemented. For these reasons, emotions cannot go unchecked.
Ignoring Risk to Reward Ratios
Any time we summarily dismiss proper risk to reward approaches, we are basically asking for the market losses. Advanced traders with successful methodologies know how to avoid these obstacles and limit the downside problems that are created when emotional reactions become apparent. In today’s markets, technical analysis entry opportunities are nearly infinite. Broad market choices can be found and traded on any time frame (using any method of analysis). Ultimately, however, success in trades comes down to rising and falling prices and we need to know when to accept losses in order to avoid getting caught short in a bull market, or long in a bear market.
When trading, we first need to have a methodical plan that identifies entry opportunities, uses proper position sizing, and obeys risk to reward parameters with a mechanical efficiency. Trading with a sense of certainty is often just a mask for the greed and fear impulses, so we always need to be willing to close positions at a loss and accept flaws in the initial technical analysis used to enter the trade. This is the only way to avoid holding onto losing positions longer than they should be kept open (and deleting a trading account unnecessarily).
Managing Emotion: 4 Tips
First, it is important to remember that there is no such thing as “certainty” in the markets. Any trader that discusses a “foolproof” method or an “assurance” that prices will rise or fall is simply not telling the truth. The market can (and will) do anything it wants, no matter how solid or thought-out your trading plan. So, while this might seem discouraging on the face of it, the fact is that this idea can be extremely freeing once it is understood that trading losses are not necessarily coming as a result of a flawed strategy. This idea also goes far when traders are forced to manage emotions during a losing trade - because there will already be some acceptance of the fact that any given position could turn in the wrong direction. This also helps you to focus on the price action itself, and not the idea that you made a mistake in your analysis.
Second, you must always use appropriate trading lot sizes. It should stand to reason that a forex trader with a $500 account should not be using the same trading sizes as a trader with a $5 million trading account. But if you look at the behaviors commonly exhibited by both new and experienced traders, this really is not the case. Conservative traders will generally avoid risking any more than 2-3% of a trading account at any one time. But it should be remembered that this is inclusive of all open positions.
Traders with a higher risk tolerance might increase this number to 5%, but anything above that is really nothing more than trading suicide. In terms of managing emotions, this is important because it will limit the thing that creates destructive emotion in the first place: unmanageable losses. In fact, smaller trade sizes can actually help you to be more objective about what is happening in the market because you are much less focused on Dollars and Cents, and much more focus on what is happening in terms of price activity in the markets. Also, from a profit perspective, winning trades are less likely to be closed early as you are not so eager to close positions as soon as they become gains. This is highly valuable when traders are looking to ride out a trend until it reaches its true end point.
Third, always consider “scaling into” a position. This essentially means you should avoid placing your full trading size all at once. Instead, you can break your trade size into thirds (or halves, quarters, etc) and add to your position if prices work against you. This strategy plays into the first rule (no certainty in the markets) and will give you an opportunity to improve on your average entry if prices do actually move in the wrong direction. This is great for protecting against stressful situations, as it means you do not need to enter into your trades with 100% precision, and gives you a buffer against adverse market moves.
Fourth, it is important to spend more time focusing on exit strategies, rather than entries. While it is, of course, very important to get a good entry price on your positions, it is ultimately your trading exit that will determine your level of profit or loss. This can also give you a mental view of the market that is healthier and more cohesive. There is a wide variety of ways to exit a positio (for example, a candlestick formation or an overbought/oversold inidicator reading). But the main thing to remember is that traders focusing solely on their position entries will be ill-equipped for adverse moves. This leads to emotional reactions that are not well thought out, and the potential to hold onto losses until they become unmanageable.
When all is said and done, the trader that is able to limit the negative effects of emotions will beat the trader that can’t in almost every instance. These four tips can help traders to manage the damaging outcome emotional responses can create. While these negative effects cannot be removed completely, it has to be remembered that there are strategies for maintaining your composure and focusing primarily on the price activity seen in the markets. The reality is that traders are rarely (if ever) able to main long and successful trading careers without practicing these methods. Conservative approaches must be applied even in the most volatile situations, and, in order to do this, traders need to have a firm hold on their emotional reactions. Without this, it is nearly impossible to make an accurate assessment of the market and generate consistently profitable trades.
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