Avoiding Psychological Traps That Ruin Your Trading

By: DailyForex.com

The mantra that 90% of the struggle to become a profitable trader is fought and decided within the trader’s own head has become a persistent cliché within Forex educational literature. Is it true, or is it just a convenient excuse to sell warmed-up, content-free New Age psychobabble at a huge mark-up? More importantly, does it mask a more sinister fact that the market is in fact random and cannot be beaten by any kind of analysis? The answers are mixed, and more complex than you might think.

There is no doubt that there is money to be made in the field of Forex education. A quick search of the net will produce a lot of material that is high on opinion and low on data. It is cheap and cost-effective to produce a little feel-good material for that section of the public that is ready to be talked out of the idea that it is gambling on short-term time frames without clear ideas of any realistic parameters. However, this in itself is not proof that the market is random and cannot be beaten by analysis.

The Illusion of Randomness

The idea that the market is random, when properly considered, is ridiculous. In fact, randomness in any context is wholly an illusion. It is just a word we ascribe to situations we feel that we cannot predict. In science, the apogee of randomness is the “Brownian Motion” experiment, where particles are observed moving randomly as they are buffeted by other unseen particles. However, if we knew the speed, mass and position of all the particles within the experiment, we would be able to predict the exact position and timing of every movement! It is exactly the same with financial markets. Price movements are caused by the value and timing of buy and sell transactions, and if we knew the intentions of every market participant we would be able to predict every tick of the market! So markets are not random, just effectively random to us on smaller time frames as we cannot possibly determine all the information required to accurately predict market movements.

The truth about technical analysis on smaller time frames is that it can provide a statistical edge, albeit a very small one. For example, certain technical formations, over large samples, might show a 53% probability that the price will reach 20 pips in one direction before the other. So the market can be beaten, even by technical analysis. It can be beaten even more easily by traders who realize that the same technical formations that show a 53% probability of 20 pips might also show a far more profitable 35% probability of 80 pips. All speculative markets can be beaten, in the long run, by strategies which cut losers short and allow winning trades to run in an unlimited fashion. This is because speculative financial markets consistently produce improbably excessive returns far more often than they would if they were efficient.

Why Do We Fear the Market?

Now we have established that it is possible to beat the market, why are so many traders, who understand and agree with my previous points, having problems with profitably exploiting the market?

This is where the New Age psychobabble comes in useful. In this context, it is not nonsense, but an accurate diagnosis. The short answer is: lack of belief, or faith. The trader is still frightened that they cannot beat the market, because the market has changed, or because the trade they are looking at taking right now looks terrible, etc. There is a long list of psychological issues that can be identified, but the lack of faith/belief is at the root of it all.

How to Believe You Can “Beat” the Market

How can this be challenged? It should be challenged on two levels: factual, and spiritual. The factual level is easier to prove. Simply construct a strategy that follows a trend on a longer time frame, uses a shorter time frame for entry, and seeks to hold positions until the longer time frame’s trend has changed while employing fairly tight stop losses on initial entries. It is best to try to trade instruments that are showing the most powerful trends also. Then test the strategy over a number of years. If the strategy is reasonably built and not over-curve fitted, you should like what you see. Note that there are losing periods, and remember these will test you far more as they play out in real time than they do as you click through a mountain of historical data over a period of a few hours of research.

The factual challenge was the easier part. What about the spiritual challenge? Deep down, most of us believe that “there is no such thing as a free lunch”. When this inner belief is combined with the fact that you have to risk money on the market in order to gain a return, we can feel foolish and guilty, like an arrogant child that is likely to harm themselves by not heeding the wise advice of their parents. This is what leads us to fail to take a trade, or close it out too early.

The first step in confronting this is to admit that the feeling exists within you. Understand why it exists. The final and most difficult step lies in persuading oneself that it is not true. Isn’t your life itself a “free lunch”? Did you have to work hard to be born? Were you born with some natural talents and positive attributes, and did you have to do any work to achieve them? Most of us are born with and continue to enjoy the unconditional love of our parents: did we have to earn that, or did it come free? Does the earth produce enough food, water and air to sustain us all, and before our ancestors took up farming, did they have to work very hard at hunting and gathering?

When you can truly accept that life itself is a free lunch, you will find that most of the battle to become a profitable trader has been won. Of course, you do need to do some work building and testing a strategy too, but that is the easier part.

Adam is a Forex trader who has worked within financial markets for over 12 years, including 6 years with Merrill Lynch. He is certified in Fund Management and Investment Management by the U.K. Chartered Institute for Securities & Investment. Learn more from Adam in his free lessons at FX Academy.