Not a day goes by when I’m not asked to counsel a new trader on trade management and realistic expectations. Expectations are not projections or probabilities. Expectations are not a statistical or analytic animal. Expectations are emotional and psychological, and trading psychology should be the most important focus for a new trader. Trading psychology will determine your success or failure over the long term, period. In this article, I will cover some core psychological areas you will need to be aware of to be a successful trader.
The first trading psychology topic I will discuss is proper trade management. What is proper trade management? Basically this:
Absolutely Never risk more then 5% of your account balance on any one trade. This means that your maximum Stop Loss on any one trade should not exceed 5% of your total account balance. For example, if you had a $1000 account, 5% of $1000 is $50. This means that your maximum stop loss should not exceed 50 pips assuming you are trading one mini contract with a value of $1 per pip. I see new Forex traders every day risking 20, 30, even 40% of their account on one trade. With that much risk, and four losing trades in a row, you’ll wipe out your account. You won’t last long taking wild risks like that, and the psychological damage will be permanent. So minimize risk. Use 5% as a maximum risk threshold. Personally, I risk no more then 1-3% on any one trade. If you have a larger account, you should follow the same rule, no exceptions. No matter how good a trader you are, it’s not unheard of to have 6-8 losers in a row. No one likes it, but if you stick with a 1-3% risk limit, expect and be psychologically prepare for it, it will roll off your back instead of breaking your spirit.
Many traders long for Van Helsing’s cross to raise when this hellish beast shows it soul-stealing teeth: Losing trades! A new trader will often feel ashamed after incurring a losing trade. He feels that he has made a mistake and beats himself up over it. Penance does no good in this life, so confess your trading sins, resolve to sin no more, but do not scourge yourself. Listen to the Truth: Losing trades are part of the game and are to be fully expected. Forgive yourself, and move on, but do not give up. It is the trading journey that overall will be correct, not each individual step. So accept each misstep. Like a shopkeeper paying rent to keep his store open, losses are part of the cost of doing business as a trader.
New traders sometimes act like impatient scientists, adopting and rejecting theories and models haphazardly. But real science not only includes patience, but requires it. An inexperienced trader may try a new system briefly. If it fails a couple times, will say “This doesn’t work” and discard it, the same way an impatient scientist might if looking at an ineffective compound for a cure for a disease. If it doesn’t work, then it must be wrong, I often hear. Perhaps however, the observed timeframe was too brief, or perhaps the compound was impure, or contaminated. This same mistake is often made in trading. A system must be applied over a sufficiently long period of time, and it must be applied precisely and without emotion. I often hear “Hey Steve, I have a great trading system. Watch me…I’m going LONG here and if it works… I’ve proved to you this is a great system, blah blah blah”. To these dear, excitable, impatient traders, I have some hard-won advice for you: If a system wins six times in row or loses six times in a row, it proves nothing! It doesn’t say anything about the value of the trading system. Do not judge a method over a few trades. Basing conclusions on statistically invalid data sets (too small, too few trades) is one of the biggest psychological mistakes the new or impatient trader makes. Trading is an art which must be mastered over time. Everyone must serve his time in the trenches, and so must every system. Every trader starts out as a losing trader, and every system starts by being insufficiently tested. Some traders lose for months while others lose for years. Some systems work for two trades, some may work for five hundred. This is why most traders leave “trading” after such a short tenure, and why systems come and go. Stamina, statistical validity, and psychological preparation are what make for a successful long-term trading career.
I see traders blow out their account two or three times, right down to zero, then start to learn from their mistakes, while simultaneously trying to build another trading account. That doesn’t work. The easiest thing in the world to do is to continue making comfortable mistakes.
Most new traders will:
Trying to be successful on every trade – Insufficient fund management or psychological preparation for eventual losses will kill you. Failure to accept a small loss – After all, it’s still a small loss, right? Nobody likes to admit that they are wrong (our human nature shies away from being wrong with more vigor than it chases profit. In other words, our own psychology encourages us to be right instead of rich, leading to seemingly sensible but financial suicidal thoughts like “A small loss can turn around and become a big profit, right?” – NO! Statistics show that when a trade has exceeded your Stop Loss Point, 8 times out of 10, it ain’t gonna come back to breakeven anytime soon. Yet, despite the knowledge that only two out of 10 times will a losing trade come back to breakeven or a profit, 99% of traders will still bet on that event! This isn’t a horserace though, it is science, and science doesn’t care how badly you wish for something. Reality only cares about following probabilities, and that is what the successful trader does without dreams or distractions. Failure to stick with a system that averages profitability – Even with a system that shows consistent net profit at the end of every month, (even though there will be losing trades, losing days, even losing weeks), most people will NOT be able to stay with it because of their emotional human nature. Trader X and I can trade the same exact system, but since Trader X will probably ‘cheat’ a little with my entries and exits – X may use market orders, I may try to save a pip and go with a Limit order, both upon entry and exit. We will have different outcomes from the identical system! Because it is human nature to try and get a pip better, or save a pip, or stay in the trade for less time and scalp the five pip gain versus staying in the trade until the ‘system’ says to get out, emotion will push Trader X to do it. This becomes an often fatal disease for many new traders. Example: If Trader X “pulls the trigger” and gets out with a five pip profit (even if the system never tells him to get out), and I follow the plan to the letter, and get out the same trade at Breakeven, Trader X may be tempted to pat himself on the back and think “I beat the master at his own system, I took a 5 pip profit, he took a breakeven. I am smarter than the developer of the system!” So, Trader X will finesse the next trade as well, and the next, and the next. He finesses until he has wandered into the statistical wilderness, all alone, leaving his system, and its hard-won net profitability, somewhere in the dark distance. Goodbye system, hello emotion and failure. The trading fields are littered with the bodies of Trader X’s brethren, don’t add to their number!
PLACE YOUR BETS
Having been around for a long time, surviving the travails of trading, using a system which, in reality, is nothing more than a set of rules that give me an edge, not a guarantee, I have been able to come back, day after day, to put money in my pocket. In effect, I am a card counter who does not look to win every hand, but to have a slight edge, so that when the laws of probability favor me, I can bet a bit more, win a bit more, and lose a bit less. I can even see myself as ‘the house’ in Las Vegas. As “the house”, I know in advance that occasionally players will come in and take large wads of the casino’s money. But I also know, with mathematical certainty, that averaged over a large number of players and plays, the house will win, because the house only needs a slight statistical edge. A larger number of experiences (rolls on dice, spin of roulette wheel, blackjack hands dealt, or trades) is needed to make it work. The “edge” only works over a large number of trades (this is referred to as “The law of large numbers”). Statistics, probability, and averages are the laws of the universe, so applying them in favor of wishes, fears, or hopes is the key to success.
IRRATIONALITY TO THE BACK OF THE BUS
So the reason why traders lose so often is simply due to a lack of understanding of their own human psychology, and a lack of the laws of mathematics. Master these two weaknesses, and you are 98% of your way to successful trading.
An irrational image that often clouds new traders’ expectations is the dream of taking $10,000 and turning it into $1 million in just 30 days! This is another enemy emotion: Impatience. People don’t want to build wealth slowly. They want “immediate gratification” – let’s “rock and roll”, “bet the farm”, “got a hunch, bet a bunch”. Of course, the cool, old, non-sexy pro’s just sit there, waiting to fleece the impatient sheep who keep trying to get rich quick, or who do not use stops properly. “Patience is a virtue” is what the pro’s mantra says, and he listens to it religiously.
These are not all of the reasons people lose their trading stakes, but they are certainly involved in the majority of cases. I can try with all the effort and sincerity I can muster to convince people to trade properly, but the odds of me ‘getting through’ are very small, and the odds of following my advice over time even smaller. Out of every 100 traders, I might get 10 who will follow my rules correctly, even for just a little while. The others will make emotional errors because the little voice in their heads drowns out mine, and keeps telling them “Come on, just this once, let’s go for it – don’t take the loss, it’ll come back, and this trade I’m in, let it ride!”.