The importance of the mental aspects of Forex trading is clear from the sad demise of Long Term Capital Management. We are not referring to intellectual brilliance or the number of university degrees but the presence of Myron Scholes and Robert C. Merton, two Nobel prize winners in economic theory, was not sufficient to keep the company from collapsing because of its own bad judgment and slipshod attitude towards risk management. The damage that can be caused by faulty psychological approaches to trading can be far more devastating than say the impact of bad analysis or faulty judgment.
The dominant emotions
There are four emotions which come into play in Forex trading and successful control of these is key to successful and profitable trading. The first one is greed and the quest for more and more profit results in a lack of discipline and focus often leads to trading losses. It is true that the quest for financial success is a major driving force but this is only within the limits of moderation and as long as it does not interfere with the logical and disciplined formulation of trading strategy. By creating an appropriate trading strategy and implementing it in a disciplined fashion, the trader can avoid the pitfalls of greed. Only investment decisions based on logical analysis of the market will be profitable in the long run.
The second emotion that needs to be controlled is fear which, unlike greed, can paralyze the process of judgment and decision making and cause the trader to hesitate about making decisive moves in the market. Regardless of the amount of analysis and logical thinking that has gone the formulation of an investment decision, fear can take two forms. Either the trader exits a profitable position early instead of realizing the complete profit that is available by holding to a logical conclusion. Or the trader is too fearful to bite the bullet and exit a losing position thereby adding further losses to the losses that have already been incurred. It is one thing for a trader to be conservative about risk and risk management but quite another to let fear take charge of an otherwise logical approach to containing risk. The conservative trader can succeed in trading profitably but the fearful trader is extremely unlikely to make a profit at the end of the day.
Overconfidence, sometimes categorized as euphoria, is the bane of the foreign exchange trader who gets carried away by temporary success and forgets that in most cases, the success is due to his diligent study and analysis of the market. Especially in the case of beginners, the string of successes that can be attributed to “ beginner’s luck” is transformed into a misplaced confidence in their own abilities and the belief that they can do nothing wrong. The trader who are successful in the long term has a healthy skepticism about his own analytical brilliance and will therefore seek to validate his analysis wherever he can before using it to create positions. The best antidote is to not to get carried away by a temporary string of profits and realize that the very next trade may result in a loss. It is only the separation of emotion from the logical process of investment decision making that can create long-term success.
The flip side of the coin is panic which causes traders to lose confidence in their own abilities and perceive losses even in profitable trading situations. This is often the reaction to a string of continuous losses and a trader tends to lose sight of the fact that other traders are trading profitably on the same currencies. Periods of extreme volatility in the market can also cause inexperienced traders to panic and make mistakes of judgment in closing otherwise profitable positions. As the panic mounts, it can be exacerbated by a high level of leverage resulting in tight stop loss levels which automatically restrict the profitability of any positions. It is important to remember that any factors contributing to the panic can be controlled by the trader and he can, for instance, reduce the degree of leverage if it is going to help.
The role of performance anxiety
Performance anxiety happens when you get so over conscious about your trading that it begins to have an adverse impact on your results. It is usually caused by the stress and pressure imposed by your desire to achieve your investment goals and can often happened in other fields such as athletics and academics. In the case of Forex trading, performance anxiety can often result in overlooking the importance of staying with your trading strategy or losing sight of the importance of risk management. There are several ways in which you can overcome the effects of performance anxiety. One of the root causes is often a tendency to perfectionism and traders should always remember that there is no such thing as a perfect trade. There is nothing wrong with the occasional trade that loses money provided it doesn’t happen too often. It also helps to concentrate on the process instead of getting hung up about the potential profits or losses as the case may be. Proper execution is as important as formulating the basic trading strategy. Finally, if you want to increase risk, do so in small increments rather than in one giant leap which could itself lead to performance anxiety. If you remain psychologically well adjusted to what you were doing, there is a good chance that you can avoid these stresses.