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Trading Psychology- Accepting the Risk

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Last updated 2/23/2010 7:28 PM EST (GMT -5) 8 Comments

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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.  We recently 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.

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 (8)

Silenus

February 24, 2010 at 02:59 AM ET

Time for a little honesty.
All our talk about risk sounds good... till we have to face our clients.
I manage my mom's money. At the end of the quarter she has only one question:
"Son, what's your Sharpe ratio?"

fxpro888

February 24, 2010 at 03:54 AM ET

I doubt your "mom" know what sharpe is or how to calculate it! but good try...and good point :P

Silenus

February 24, 2010 at 04:39 AM ET

What? Return minus risk free alternative divided by standard deviation.
Like that's hard? Duh! You underestimate my mom dude.

MoneyManager

February 24, 2010 at 04:44 AM ET

If your mom wants that on a quarterly basis, I would refuse to manage her money until she wised up. :)

bgareiss

February 24, 2010 at 02:07 PM ET

The Sharpe ratio is the effect, not the cause. I don't think an article that read "trade well so you have a good Sharpe ratio" would be very useful. On another note, the Sharpe ratio has flaws. For example, Long Term Capital Management had an excellent Sharpe ratio, but the ratio didn't factor in that they had massive illiquid positions that quickly dissolved the fund in a few months. In other words, it is difficult for a simple ratio to thoroughly measure risk. The Sharpe ratio is better than nothing, but it is not the be-all end-all. Brad

Stevie G

March 14, 2011 at 05:28 PM ET

Brad: Just wondering if you have an article that includes a trade invalidation for the EURGBP that is currently posted

bgareiss

March 14, 2011 at 05:30 PM ET

Here is the original article: http://www.fx360.com/commentary/brad/5066/will-eurgbp-resume-downtrend-at-08746.aspx

Brad

okpasha

February 24, 2010 at 05:11 AM ET

*sorry off topic**Anyone else see the reversal taking place the last few weeks most noticeable with Gbp/Jpy -(only dives every few months and stays set for awhile). With toyota taking a betting in congress, euro woes(which saved the greenback), usa unemployment, etc etc. check your positions as the tide is shifting.

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