Trading Psychology- Accepting the Risk

Last updated 2/8/2010 8:49 PM EST (GMT -5) 8 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 futures results.

Bradley W. Gareiss

Technical Analyst, GFT

Trading psychology is the most important aspect of a trader's success. I have made this statement before, but it is worth repeating. There are many factors that contribute to a trader's psychological makeup, and there is no easy way to attain a trader's mindset. However, there are certain factors that influence a trader's psychology that are important to be aware of. Several weeks ago we published a feature that covered how a trader should deal with a drawdown ( Trading Psychology- Dealing with a Drawdown ). That feature discussed the psychological implications of losing over a series of trades. Today's topic, accepting risk, pertains to individual trades rather than a long string of trades.

The best traders typically are the most consistent traders. In order to be a consistent trader, it is important to consistently apply one's methodology to the market and make as few errors as possible. A trading error is when a trader deviates from their methodology. Common errors include taking a bigger loss than planned, exiting a trade earlier than planned, taking a trade that does not fit the trader's usual criteria, or passing on a trade that fit the trader's usual criteria. These errors can be destructive to a trader's capital and sanity.

Trading errors are usually induced by emotions caused by previous trades. The most dangerous emotional catalyst (in my opinion) occurs when a trader loses a trade they felt was a certain winner. After losing this trade, a trader feels sad, angry, or even vengeful against the market. This causes a trader to enter a trade irrationally in order to win back what they felt they were cheated out of. Of course, this trade usually is a loser. If it wins, this can be even worse, because it encourages this type of decision making in the future, which could lead to even larger losses.

In my opinion, the reason the aforementioned scenario is common among traders is that they did not accept the risk when they placed the trade. They thought the trade was a sure winner, so it was miserable to take the trade as a loss. In fact, traders may even refuse to take their loss because they were so sure it was a winner, which can lead to devastating losses. This is why traders must accept the risk of each trade before they enter their position. In other words, a trader must view the amount of money they are risking as an expense to see if their trade idea will work. Once a trader accepts the risk, they will typically feel far less distress if the trade does indeed lose.

Accepting the risk of each trade is not easy, especially for inexperienced traders. Of course, there are some steps we can take to make it easier to accept the risk. First, it is very important to plan out each trade. This means we should know where we will enter the trade, place our stop, and place our take profit level(s). That way there are no decisions that need to be made once the position is entered. The human brain will view information differently once that position is entered and it thinks much more clearly before the position is entered. Additionally, if we know the distance between the entry and the stop, we know exactly how much capital we are risking. This is important because it is impossible to accept a risk when we do not know how large the risk is. After entering the pre-planned trade, emotion is inevitable, but at least it won't impact the result of the trade.

As we said earlier, a trader must view the amount of money they are risking as an expense to see if their trade idea will work. Every trader has losses. However, consistent traders view losses as business expenses. Losses are a necessary aspect of trading, and there is no way to know which trades will win or which will lose when the trade is entered. Therefore, if we can accept the risk of each trade before placing it, these losses can more easily be viewed as part of trading rather than a personal attack from the market. Once a trader learns to accept the risk on every trade and concede they don't know which trades will win, it will be much easier to control one's emotions and achieve consistent results.

Comments (8)

gabri558

February 09, 2010 at 12:54 AM ET

Hi Brad,

I have a question on Risk / Reward ratios.
I am a short term (30-mins. chart) trader n' it is often very difficult for me to achieve lower risk / higher reward ratios.

Let us consider a short term trader who is looking to make 20 pips on a trade. If he was to maintain a 2:1 risk / reward ratio, his stop would need to be 10 pips. However, 10 pips is just little bit more than the spread for many currency pairs which means that the risk of being stopped out is very high.

In this instance, how do one achieve a lower risk / higher reward ratio?

Could u kindly advice on this BIG headache of mine?
Appreciate that. Thanks!

Gabriel.

Partiscae

February 09, 2010 at 01:07 PM ET

You might want to consider the probability adjusted reward/risk ratio. This is how you calculate it: (percentage of winner trade X reward component / percentage of loser trade X risk component) : 1. Lets say you have a setup that yields 6 out of 10 letting you down only 4 times and you maintain the above mentioned 2:1 r/r. (6X2/4X1):1 gives you 3:1 r/r. This method draws attention on the importance of the use of reward risk ratio in conjunction with the particular setups. Mathematically 1:2 r/r/r yields if the setup works out 67 percent of the times! A tarder looking to make a few pips on each trade in my opinion has to work on skewing probability in his favour as well as giving up on flashy r/r/rs.

bgareiss

February 09, 2010 at 01:16 PM ET

Gabriel, your example is the reason that I typically look at setups that are on a larger scale. I typically like the distance between my entry and my stop to be at least ten times the spread. In other words, if the spread is 5 pips, I would want a stop of at least 50 pips. Sometimes I will enter a trade if the numbers are a little off, but that is the ideal minimum. In my opinion, a 10 pip stop is asking for trouble, especially if you include the spread in that figure. Brad

gabri558

February 10, 2010 at 04:32 AM ET

Thanks Partiscae n' Brad! Appreciate your reply.

Brad: U mention 'look at setups that are on a larger scale'.
Can u kindly elaborate on this n' any recommendations?

Thanks once again.
Gabriel.

bgareiss

February 10, 2010 at 02:38 PM ET

As I said above, I prefer the distance between my entry and stop to be ten times the spread. That is a good benchmark. The longer term your trades are, the less likely you are to be stopped out on a small spike. However, if they are too long term then you may have to wait weeks for the trade to exit. There is no concrete definition of these time frames because there are too many variables that require interpretation (currency pair, volatility, historical volatility, news announcements, spreads, etc.) Regardless, I suggest working to find your own comfort zone with this because everyone is different. Brad

NeoFX

February 09, 2010 at 03:14 PM ET

Brad, first of all, thanks on the GBP/AUD word of advice. I agreed at the end as I stayed out of it. (though it did dip over 150 pips as I thought----it just did it after only hitting the 38% ret).

either way, my questio to you is:

are there any products/services out there that you'd recommand looking up as a learning tool? CD's, books, e-books, etc..


are you aware of any solid training material out there really worth considering?

thanks in advance

R

bgareiss

February 09, 2010 at 03:22 PM ET

For trading psychology, I would check out "Trading in the Zone" by Mark Douglas. For trading using the patterns, "Trade What You See" by Larry Pesavento is a good place to start. Brad

NeoFX

February 10, 2010 at 02:07 PM ET

THANK YOU, BOSS!!

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