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Review: Trading Psychology and Drawdowns

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Last updated 2/17/2010 6:42 PM EST (GMT -5) 13 Comments

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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 on 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 expects 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 occasion, 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 some form of analysis and some 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, draw downs 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 whatsoever 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 fundamentals 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.

In conclusion, the steps above illustrate the general process a trade takes on the road to achieving consistent results.  Virtually all traders only become successful after they able to put together a strategy that gives you an edge, money management, and proper trading psychology.

The information, including Commentary and Trade Ideas, provided on FX360.com should not be relied upon as a substitute for extensive independent research which should be performed before making your investment decisions. Global Forex Trading and FX360 .com is merely providing this information for your general information. The information and opinions presented do not take into account any particular individual’s investment objectives, financial situation, or needs. All investors should obtain advice based on their unique situation before making any investment decision and should tailor the trade size and leverage of their trading to their personal risk appetite. Any projections or views of the market provided by FX360.com may not prove to be accurate.

The views of the authors and analysts are not necessarily those of Global Forex Trading, its owners, officers, agents or other employees. FX360.com and the currency research team will not be responsible for any losses incurred on investments made by readers and clients as a result of any information contained on FX360.com. Global Forex Trading and the currency research team do not render investment, legal, accounting, tax, or other professional advice. If investment, legal, tax, or other expert assistance is required, the services of a competent professional should be sought.

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Comments (13)

fxlrodas

February 17, 2010 at 07:57 PM ET

You are right, Congratulations excellent article.

bgareiss

February 17, 2010 at 08:53 PM ET

I am glad you liked it. Brad

FX4Sure

February 17, 2010 at 09:08 PM ET

Well, subjectively I've been thinking that money management priors psychological aspects, but that was because I tough psychology was only to keep your mind cold and don't get emotions to control you, now I've changed my mind as I see you taking it so seriously and deeper, I will research further.

Thanks

srry for bad english

bgareiss

February 18, 2010 at 01:10 PM ET

Hopefully the article helps. Money management is important, but I think that is much easier to deal with than the psychological aspects of trading. Brad

margaret

February 17, 2010 at 09:26 PM ET

Brad, thank you for another engaging session. I can completely relate to your words.
PS Neofx's posts helped me keep the GBP/JPN going and its going OK (thank you NeoFX). Got fed up with the NZD/CAD trade not enough action - until I closed it -then it started to travel down. Trading psychology in action!!

bgareiss

February 18, 2010 at 01:20 PM ET

I am glad you liked the article. I think a big step to avoid those type of mistakes is making a plan for as many outcomes as possible and sticking to it. Brad

Callum

February 18, 2010 at 05:48 AM ET

Nice article. Some say trading psychology attributes to over 50% of trading success.

One of the best books I read on this subject by Dr. Elder. Trading for a Living: Psychology, Trading Tactics, Money Management http://bit.ly/a3bo81

bgareiss

February 18, 2010 at 01:12 PM ET

A good book to check out on trading psychology is "Trading in the Zone" by Mark Douglas. Brad

Silenus

February 18, 2010 at 07:02 AM ET

Totally agree!
I mean pretty much any reasonable sys will work if applied consistenty (e.g: Long above/Short below X day MA)
Money management is even simpler: Don't use leverage!
Psy is the hard part. Some people just don't have the amygdalae for it.
Not sure you can do anything about it tho.

bgareiss

February 18, 2010 at 01:14 PM ET

I agree with all of that except the bit about leverage. I think leverage gets a bad reputation. In my opinion there are far more important factors in controlling risk. In fact, I think I will write an article about leverage sometime soon because there more to say than would fit on the comment board. Don't get me wrong, I don't endorse being too risky, I just think leverage is misunderstood by a lot of traders. Brad

Derekis

February 18, 2010 at 09:56 AM ET

Hi Brad,
Once again your article hits the nail right on the head.
I totally agree that trading psychology is the most vital aspect of any successful trader's makeup.
In fact, I personally believe that Trading Success (100%) = Psychology (55%) + Money Management (30%) + Strategy (15%).
The Holy Grail of Trading boils down to your trading psychology and mindset.
Thanks for a great article.

bgareiss

February 18, 2010 at 01:18 PM ET

I am glad you enjoyed the article. I don't think there is a "holy grail" in trading, but there are definitely steps you can take to increase your chances of long term success. I speculate that trading psychology is the biggest area of opportunity for most traders to improve on. Brad

dwt

February 19, 2010 at 02:49 PM ET

Becoming a successful trader is a journey of 1000 miles, but the last 6 inches are the hardest. Those are the 6 inches between the trader's ears...

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