Trading Psychology- Dealing with a Drawdown

Last updated 5/19/2009 7:40 PM EST (GMT -5) 11 Comments

Forex Trading involves high risks, with the potential for substantial losses and is not suitable for all persons. Past performance is not necessarily indicative of future results.

Bradley W. Gareiss

Technical Analyst, GFT

Trading psychology is the most important aspect of a trader's success.  This may surprise some readers, specifically those that are new to trading.  However, the psychological makeup of a trader is more important than market knowledge, market analysis, and even money management.  The reason psychology is so important is that even the best information can be distorted by a poor mindset.

Most new traders think the key to profiting in trading is knowing more about the market.  For instance, most new traders clog their screens with every indicator they can find, read up European GDP trends, and feel that pro traders have some sort of secret knowledge.  However, this inevitably does not provide the lofty results the novice trader hopes to achieve.

After realizing that excessive market information doesn't help (and may hurt) results, the next moment of truth most traders have is money management.  Instead to trading 1 lot every time, or even trading the maximum lots their account will allow, these traders realize losses will happen no matter what.  When you realize that everyone loses on occassion, it is easy to see why money management is necessary.  This is a big step, but does not ensure success.

Now, don't get me wrong, you need to have a form of analysis and a form of money management to profit in the long term.  In other words, you need an edge that when applied with proper money management leads to positive returns over the course of many trades.  Great money management with no edge will only mean you lose your money more slowly.  A great strategy without money management will lead to an inevitable blow up.  However, without the proper mindset, it is nearly impossible to continue to get good results in the long run.

The bottom line is that a poor mindset can sabotage even the best trading strategy or money management strategy.  I could write about this at great length, but we will look at one key example for now.  The biggest test in trading psychology occurs during a drawdown.  This occurs when a trader gets in a "slump" and has bad results for a given period of time.  Usually the most devastating drawdowns eliminate a significant amount of a hard earned profit.  

Keep in mind, drawdowns are completely normal.  Everyone has them on occasion.  However, the key is reacting properly to drawdowns.  This is why trading psychology is so important.  The natural reaction during a drawdown is to change your strategy.  Sometimes traders will even take trades for no reason at all except for a desperate chance at a profit.  Assuming you believe your methodology is sound, there is no reason to change anything during a drawdown.  In fact, that is the most important time to follow the basics.  Think about a baseball hitter in a slump.  Sometimes they will change their stance, but usually they keep the same basic stance and swing.  Instead, they focus on the fundatmentals of keeping their head still, keeping their hands back, and so on.  For some reason traders tend to panic in this situation and change everything up.  This leads to a larger drawdown, which usually ends when the trader reverts back to their primary strategy.

As this is a key topic with many topics to discuss, we will come back and discuss another aspect of trading psychology soon.  

Comments (11)

FXMT2009

May 19, 2009 at 10:19 PM ET

Please write more about this subject....in details....how long have you been trading and what do you do what hit the wall?

H Taylor

May 19, 2009 at 10:38 PM ET

Great essay Brad! Perfect timing as well. We took a beating on the geometric patterns this week! I am fairly new to Fx and have enjoyed a modicum of success as a part time trader. When my friends notice some of my toys and want to get in the currency market, I point them to articles like this one. People who are used to trying to pick tops and bottoms in stocks get frustrated (and broke) really quickly in Fx trading. I also tell people that you need to have the discipline of a Marine and the mindset of a pilot for this market. Your checklist is your trading plan and you stick to it religiously with a measurable goal so that you can see how well you're doing. If you don't use your checklist and don't tenaciously stick to your plan, you have no way of measuring how well your plan is working.
I have a very simple plan that use to swing trade and it has worked very well for me. I have recently been following you on trades as well. I'm trying to learn some of the more sophisticated longer term patterns that you employ. It has been a fantastic learning experience. I was right there with you on that Aussie Buck trade and can honestly say that if the same pattern presented itself next week, I would enter again without hesitation. Adding another wrench to my mental toolkit by riding a trade over many days, including weekends, was worth the cost of the class. As you say in your essay, by practicing proper money management, (2% for me) I knew what I had invested when I pulled the trigger. I read somewhere that the time to worry and fret is before you place your bet, not after the wheel starts spinning. Plan the trade and trade the plan.
Thanks again for the commentary and the advice. You guys are all fantastic.

Best,

-H-

bgareiss

May 20, 2009 at 08:12 PM ET

Thanks for the comment and I am glad you are employing a proper money management strategy. It is touch to stay in the game long without one. Brad

Murat_B

May 20, 2009 at 02:58 AM ET

I think it also helps to sit back a little, relax, watch the market and trade on demo for a while when you're in a "slump'. To gain confidence in your trading system and get a feel of the market once again.

Very useful site and I'm very grateful to you guys for all the work you are doing.

bgareiss

May 20, 2009 at 08:10 PM ET

I agree that it helps to relax. Although I know from experience that easier said than done when you have real money on the line. Thanks for the comment. Brad

Satish Shetty

May 20, 2009 at 06:12 AM ET

Dear Bradley,
I am with you, about Psychology in trading, and i think Psychology is not only related to forex but also for stocks, commodities and may be many more.
Well first up all THANKS A MILLION for posting great picks and articles. I always read posts on this site and today thought to put some words.
You guys are doing awesome job. It really helps for everyone right from new comers to experienced.
One request - If posible please try to post your replies to our comments , i can understand it may not be possible for you guys for every comment but atleast one comment in a day. Its request.
Thanks alot once again.

God bless you all and your firm.

regards
Satish Shetty

bgareiss

May 20, 2009 at 08:13 PM ET

Thanks for the comment Satish. We try to answer as many comments as possible and will continue to do so in the future. If you ever have a question in a comment that goes unanswered, feel free to email us. Brad

FXMT2009

May 20, 2009 at 07:01 AM ET

Sorry I was not clear in my last post, what do you do when you hit the wall, do you take time out or try to change your strategy?

bgareiss

May 20, 2009 at 08:16 PM ET

In my opinion, the worst thing to do is constantly change your strategy because then it is tough to tell what is working and what is not working. If the strategy has worked for hundreds of trades across a long time frame and many currency pairs, you probably want to give it a longer chance to work itself out if you hit a wall. If you are newer and don't have that track record, I would suggest testing the exact same rules for at least 20 trades (maybe up to 100) before changing anything. It is difficult to know what is working and what is not working in fewer trades. If you are feeling emotionally drained I suggest taking the rest of the day off but not much more. One day off and some sleep can do wonders for a trader's attitude. Brad

LongTermProfits

February 24, 2010 at 09:51 AM ET

just seeing this for the first time now so i had to comment

great article!

the article you sent out today dealing with risk is outstanding as well

these are my two biggest obstacles when it comes to the fear element in my trading: accepting risk properly and dealing with drawdowns

thanks for the great articles!!

bgareiss

February 24, 2010 at 02:11 PM ET

I am glad you enjoyed them. Brad

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