Thinking about forex trading in the right way is central to doing forex trading in the right way, yet it isn’t discussed nearly enough. But why learn things the hard way when you can start out with an awareness of the key issues?
Getting into the right headspace for trading is a pretty boring subject compared to the really exciting stuff like getting into your charts, actually pulling the trigger on trades, adjusting your stops, and taking profit. But getting into the right mindset and getting yourself prepared for trading is just as important as all of those put together.
There’s a ton of experienced traders out there who wish they had had someone to sit them down at the beginning of their trading career and explain to them a few of the key fundamentals that they have now learned the hard way – through bitter experience – but that they could have started out knowing. Most of the lessons this imagined trading guru would have taught them are about the mindset you develop going into trading in the first place.
The Right Mindset
This is one of those things that people have the hardest time getting their heads around and understanding to a level that really impacts their trading.
Think back to the first time you encountered trading. Not even the first time you thought about getting into trading yourself but the first time you even came across the concept of trading and investing and using your money to make more money. If you are anything like most traders out there, this would probably have happened to you when you were a kid and you first heard about these people out there who call out buy and sell orders over the phone or whatever and who track the price of some security or other online charts with crazy ups and downs. Chances are you would have seen this at the movies or on TV and which particular show or movie you first saw this in kind of depends on how old you are and what generation you belong to. For a certain (read: older) cohort of traders, it was those 80s and 90s movies about stockbrokers, like Wall Street or Other People’s Money. The point is that this era of TV shows and movies really inspired a whole generation of traders to think that they could get into stocks and shares and make big money overnight. That generation had to learn the hard way that overnight success takes years to achieve.
Put another way, they had to learn and understand that trading (whether its commodities, stocks, forex, or whatever) is much more like a genuine, bona fide professional career. A career that takes hard work, experience, learning, and commitment to master. Sure, there are a few outliers here and there who got lucky and rolled in some big bucks with little effort from the moment they started. But you have to remember here that at the other end of the bell curve there is a whole other set of outliers who just got wiped out immediately. For everyone else in the middle of that curve, there are no alternatives to learning the ins and outs of the craft – in the same way as you would learn any other profession or trade.
Knowing the Difference Between Good and Bad Trades
It is important to focus on making good trades. But what, when it comes right down to it, is a good trade? Now, lots of traders will have their own definitions but a few elements are essentially undeniable. One is that a good trade can sometimes be a trade that loses money. What? Say that again! Yup, that’s right, a good trade isn’t always a winning trade.
But how is that possible? Well, that’s why it’s important to understand what a good trade is. A good trade is one that you entered into having done all of your homework. You developed a system of indicators and technical criteria; you worked out how to manage your stake in a given currency pair based on things like volatility and risk; you calculated reasonable stops to take you out of the trade in case things turn sour; you stayed in the trade in line with the plan and system you devised to maximize your gains. In short, a good trade is one that you carried out in line with a comprehensive and rigorous system of your own devising that has been tested and adjusted in order to maximize gains and minimize losses.
Sometimes, not trading is an important element of making a good trade. There’s no rule out there saying you have to trade and staying out of a trade that would have lost you money is one of the best ways of avoiding losses. If you are knowingly and consciously staying out of trades because the tools and indicators that you have integrated into your system are telling you not to trade, you are exercising the kind of patience that is important to making good trades. An amateur or beginner trader will be tempted to enter into trades on the basis of boredom or because they are worried they haven’t traded in a while. They are not patiently waiting until all of the conditions are in place and all of their criteria are fulfilled before entering a trade.
A good trade that loses money, therefore, will also take you out of that trade in a timely manner that will keep that loss to a minimum. A bad trade that loses money will see you spiraling out and losing more than you planned for or more than you accounted for in advance. Every trader out there enters every last trade they make thinking that it will be a winner. In fact, most amateur traders out there will have more winners than losers but they will still be losing money in the long term. How’s that possible? Well, because their losers are often much bigger than their winners. This is because they fail to bug out of a losing trade on time and, on the flip side, they fail to stay in the winners long enough to take advantage of the gains. Because there is no way of knowing in advance which of your trades are going to be winners and which are going to be losers, you have to enter them with the same set of contingency plans in place to cut your losses should things go south and stay in the trade to the appropriate point that will maximize your gains. This is the basic concept of risk management. The way you trade has to be organized in advance to account for an unexpected shift in the market.
Going hand in hand with being ready to cut and run when things aren’t going your way is a well-planned approach to letting winners develop to take full advantage of the gains available. The way to understand this is to tell yourself that it ultimately doesn’t matter how you enter a trade. The criteria that lead you to enter a trade aren’t the key thing to making money from trading. What makes you money is managing your money and accounting for risk – i.e. staying in trades long enough to reap the rewards and getting out of them quickly if they are performing badly. If you can design and develop a system that does this reliably for you, you can still make money even if your win to loss ratio is 50-50 or less.
Focus on the Pips
Pips are to forex traders what dollars and cents are to stock traders. In equities and commodities, you’re looking to profit from your trades in dollars and cents – if you buy a stock when it’s worth $4.30 and sell it when it’s worth $4.70, you made forty cents. Well, in forex trading you’re looking for your trades to make pips. Pips (or price interest points) are the smallest amount of a currency that can be traded. A pip is one one-hundredth of one percent – the smallest amount by which the difference in value between two currencies can change.
Focusing on pips is one way to shift your focus away from the actual money you are making (or losing) on a given trade. But why would you do this? Well, part of the answer is that this helps you to focus on making good trades. Over-focusing on the money does a couple of things that will hinder your trading. First, it clouds your judgment about which trades are good trades. The other thing that over-focusing on the money does is introduce a completely unnecessary emotional element to your trading. Without consciously wanting to, you will start thinking about what that money means in the real world – whether it’s the bills you can pay or the things you can buy – and suddenly but imperceptibly you’re experiencing an emotional response to the trade you’re entering or the stop you’re adjusting or the exit you’re planning. If you could remove money from the equation completely and focus instead on the success of each trade on an abstract level, your trading would improve automatically. This is why focusing on the pips helps to remove you at least one step away from thinking about the money involved in trading.
Avoiding Bad Trades
Just as a good trade can lose money, a bad trade can make money… Usually completely by accident. A bad trade is one that you entered into on a feeling, with a sense that it would pan out how you hope. Usually, if you’re making bad trades you don’t even have a well-worked-out system in place to regulate your trading or, if you do, you’re not sticking to it on the back of some emotional response you’re experiencing. There is a multitude of factors that go into what makes a trade a bad trade but they include not accounting for risk; improperly sizing your stake based on how you feel this trade will go; placing stop or take profit orders based on fear or adrenaline, or even failing to even place a stop order at all because you have a hunch that any pullbacks won’t be full reversals.
It’s actually very simple really. Traders who lose money in the long term are the ones who either don’t have a system in place to manage their trading or don’t stick to their system if they have one. Because you know what will happen from time to time? You’ll hit a run of losing trades and that’s when you’re in real danger of reacting emotionally and overriding the system you have put in place to stop you from doing just that. Let’s say for example that you run up five losses in a row. That’s when you start to question everything. Is your system failing? Are you sticking to it too rigidly? Here’s a common reaction.
Lots of traders will look at their sixth trade after a run of five losers and begin rethinking their position size. Some will lose confidence and cut their position size because they’re worried they’re heading into another loss. Others will try to use that sixth trade to win back their losses and will up their position size to compensate. Both of these responses are mistakes. You are letting your emotions override what is otherwise – if you’ve done it properly – a reliable and robust system that has been tested to death both by looking at historical market movements and by being run through a demo account.
Another common emotional response is when you’re in a trade and you see the price heading in the opposite direction to the one you were banking on. You’re watching the price move and you can see it approaching your stop-loss. Many inexperienced traders – especially those coming into the trade on the back of a losing streak where the price burned through their stops and then recovered – will be tempted to panic and cancel their stop order hoping to stay in the trade until it swings back in the direction they need. Sitting here, calmly reading this, you can immediately see the problem with this – the price doesn’t recover and your losses run out of control. It’s having the presence of mind to see this happening in the heat of the moment and exercising enough self-control to stick to your system.
Lastly, those traders who have stopped listening to their system (if they even have one) and are letting their emotions rule their trading, will also make this mistake. Sometimes, when you get in on a good trade and the price goes your way, you lose track of your charts and indicators and you start looking at the money. It’s probably happened to most of us early on in our careers. The price moves quickly after we pull the trigger on the trade and our gains start going up. You get lost in the excitement and start making quick calculations in your head that go something like this: “Oh man, can’t believe it, I just made 500 bucks and before breakfast too! I can put down that payment on my car/pay those bills/buy that thing I’ve had my eye on”.
In other words, you over-focus on the money and you pull out of the trade. It’s only later when you look back at the price movement that you realize you could have stayed in longer and increased your gains even more. That kind of emotional moment of getting out of a trade too soon is literally the opposite of what you should be doing. You should be exciting your trades based on a rational assessment of what your system is telling you. If your indicators are telling you the price movement still has legs, then stay in and adjust your stops accordingly. Exit only when your system tells you to.
So, to sum up, if you can get your head around the fact that bad trades are bad for your trading even when they make money, you are well onto your way to never making a bad trade ever again. If you can focus on making sure you trade according to your system and that every trade you make is a good trade, as we’ve set out in the previous section, then you are on the first rung of the ladder towards becoming a successful, professional trader.
Get Some Perspective
Another important element of getting yourself into the right mindset is maintaining perspective. This is a hard one, especially early on in your trading career. Because this is something that usually comes with experience, it is hard to explain to traders who are still on that steep learning curve. That said, it’s well worth talking about because being aware of it as a factor is going to help you to get there faster.
The fact is that every trader goes through a process where their state of mind depends on their last day of trading. You trade for a day and if that day went well, you feel great. But if it didn’t go well, your mood suffers and you start to lose hope. Sometimes, after a couple of days of losses, even if they were just minor losses, you can go into a weekend feeling really blue. Now, there are a couple of problems with that. The first is that it is downright exhausting. You feel emotionally drained and that can have knock-on effects in your life outside of trading. And here’s the thing – that’s not the point of trading at all. If forex trading is having that effect on you, if it’s getting you down or even making you feel depressed, you’re no longer enjoying it and you begin to see it as a chore or a burden.
The other problem is that these mood swings can affect your trading. You become a confidence trader – one who’s trading starts to depend on how confident they’re feeling at that particular time. And the more that happens, the harder it gets to stick to your system, and the less you stick to your system, the more bad trades you’re going to get into. If you find yourself making bad trades, pretty soon you’re going to be losing money. It’s a cruel spiral that you can fall into if your mood becomes dependent on how your trading is going. Which is why it’s important to maintain a bit of distance and perspective.
One way to help yourself maintain perspective is to introduce some regularity into your trading. If you find yourself trading too often, getting online as soon as the markets open, and regularly getting into trades as soon as it is at all possible – then you are probably trading too much. Of course, everybody will have a different rhythm to their trading and some people will be trading twice as often as others, that’s perfectly fine and you should find your own pace. But the thing to watch out for is if you start trading too often, out of boredom or because you’re chasing an unrealistic profit target or goal.
Obviously, setting yourself goals is important but people start to give them too much importance. They start focusing on whether they hit their target over the last week or the last month. But they forget that everybody has a bad week or a bad month here and there. Even most successful traders have one or two months where they lose overall. Not that they fail to hit their goals but they lose overall during that month. And yet, when you look at their balance for the year, they’re making great profits.
Those traders are the ones who have managed to rein in their trading out of boredom or desperation, they’ve managed to focus on their system and – whether they win or lose – they’re making good trades time and again. If you can do that, over time you will get to the point where you aren’t relying on having a good trading day to be in a good mood because you will have realized that your trades from today don’t affect your score for the month or for the year. Once you know that your next trade or even all of the week’s trades will not affect your performance over the long haul, you can get some emotional distance between the trade you’re going into or the one you just exited and how you feel about yourself and your trading. Ultimately, that distance and perspective is going to be good for your trading too, and probably for your bottom line.
Trading by the Numbers
Understanding the numbers that underpin your trading is probably the most important thing in forex trading or any other kind of trading. If you don’t understand the numbers behind trading, you’re not trading, you’re gambling. And not only are you gambling, but you’re also gambling without knowing the odds.
Understanding the numbers means having a good sense in advance of what kind of win/loss ratio you can expect from the system you’ve developed. Of course, the market being what it is, you’ll never know fully but with a robust testing regimen, you should have a good overview of what to expect.
Coupled with having an estimate of your win/loss potential calculated ahead of time, you should also have carried out a risk to reward assessment. That means that you should have worked out how much you are willing to risk for a given profit, taking into account such factors as the size of your portfolio. Here you can also factor in such things as your profit factor (how much you gain compared with how much you lose) or the Sharpe Ratio.
Before you start trading in the real world, you can take your system for a spin through a simulator and get all these numbers. Until your system is reliably producing positive numbers, you’re not going to be a successful or winning trader. If you take a system that doesn’t produce positive numbers into the real world, there is no other way o putting it than you are going to lose money. That’s a fact.
Once you’ve tweaked your system to the point that it produces positive numbers in simulators and demo accounts, you’re ready to give it a run-out in the real world. But if you think that’s where the learning curve ends, you’ve got things backward. That’s where the real learning begins.
Evaluation and Evolution
In a sense, being a trader is about always being honest about your past mistakes so that you can keep on learning from them. In the same way, it’s important to develop and design a system that reliably produces positive outcomes and that you test that system thoroughly before you let it loose in the real world, you will also want to go back and reanalyze and reassess that system so that you can keep improving it. If you can keep adapting and evolving, you can continually improve your skills as a trader and go from success to success. As with anything else in forex trading, this is much easier to say than to achieve. It takes work, organization and it takes an investment of your time but the rewards can be handsome.
You’ll never learn from your mistakes if you don’t know what your mistakes were. So, the first step is to get in the habit of keeping a trading diary. This doesn’t have to be anything too fancy or complicated, just a record of your trades and just a short note on what your reasons were for going into each trade. These days, people don’t bother to do that because the platforms everyone is using to trade these days will keep a record of every trade. And, to be sure, that’s a good starting point. However, you will find that you’re looking back at a trade you made at the beginning of last year and that your system has changed in the meantime and there’s a good chance that you won’t be able to remember what criteria led you into that trade. That’s why keeping a note for each trade is a really valuable tool. Also, it will help you to stay out of emotional trades because you’ll find it harder to justify these to yourself and your trading diary.
If you’re able to keep a regular trading diary over a given period – say the first six months of real-world trading – you will be able to see the benefits as soon as you look back over that period. Even after just six months of trading, you will be able to look back at your past performance and spot a multitude of mistakes that you can learn from and eliminate. But more than that, you will be able to see patterns in when and how you trade. You might surprise yourself and see that you trade more rashly following a run of losing trades or that you are more focused and successful at the start of the week as opposed to the end of the week where you get sloppier.
There’s probably a huge number of ways to keep a trading diary or to track your trading – some people have complicated spreadsheets with charts and ratios, others keep physical diaries they write out by hand. But the key to successfully tracking your trades so that you’ll be able to go back and evaluate your outcomes isn’t how you keep the diary or how you organise your records. The key is being honest with your future self. If you’re prone to bending the truth (even if it’s by omission) when you keep your records, you won’t be able to learn from your mistakes as effectively. And it’s easy enough to do, especially after a really big losing trade or a run of losing trades when the temptation is to say you stuck to your system and that it was just the whims of the market that meant your trades didn’t pan out. But, if you’re honest, it might reveal that you had traded rashly or that you oversized a stake in the hope of making up for past errors. When future you looks back on that, the learning experience will be more valuable than any gain you could have made from that rash trade.
If you want your trading to be a system that is undergoing a constant cycle of evolution and improvement, one way of achieving that is to constantly be running testing. All experienced traders will talk about testing until they’re blue in the face but, when you’re just starting out, you tend to hear that and understand it to mean that you should test all the components of your system and your system as one functioning whole. And sure, you should definitely do that. But the successful traders out there will constantly be testing something. Whether it’s a new indicator they came across or a slightly different variation on their current system. Or sometimes a radically different approach that they’re just taking for a spin in their demo account to take it apart and see how it works.
You can think of yourself as a part-time trader, part-time R&D specialist. Because while you’re trading with your system in the real world, you can also tinker with a host of tools or other systems in demo accounts and simulators. This way you’ll keep the learning centers of your brain ticking over and avoiding getting stuck in a rut. But also, this will enable you to keep your trading system up-to-date and always finding new ways to do things better and better.
The best and most successful traders out there are controlled, calm under pressure, disciplined, consistent, and rigorous. Very few people out there manage to be all of those things naturally, while they’re still dreaming of a career in forex trading. For the rest of us, it takes time, diligence, hard work, and a seemingly unending cycle of learning from past mistakes and making new ones to learn from down the road. But if you know and understand that going in, you can also do a few relatively simple things to make life easier for yourself. Or, better yet, make it easier for yourself to do the hard things that are indispensable if you want to make forex trading work for you. Because, at the end of the day, your only real job as a trader is to mold trading into something that makes your life better.