Structuring a Plan for Trading
Before we get under way with this lesson on risk management and trader psychology, it should be pointed out that the information presented here is for educational purposes. The information and techniques presented are for a new trader’s consideration when entering the world of Forex trading. By no means does a trader have to use any of the techniques in this lesson, but it is worth your time to read through it and consider whether it is something you may want to incorporate. The examples and numbers used in the examples are not meant to be used literally; they are picked as an easy way to illustrate how the techniques work. With that in mind, let us begin.
A very important aspect to the psychology of trading is the ability to create and maintain a trading plan. As a famous saying in the market goes, “if you fail to plan, plan to fail.”
Planning is closely linked to the discipline of a trader. Experienced traders know that discipline and a trading methodology are key to long term survival in the financial markets. It’s common for very new traders to make money on demo accounts, but many times these same traders lose when entering the live market because they fail to exercise discipline when real money is involved.
This lesson will outline some principles to creating a trading methodology along with techniques for risk and money management. New traders that jump into trading with their only goal being quick and high returns have a good chance to wind up losing, because they do not focus any energy on long term survival or steady capital growth.
The first step to creating a viable trading plan is to determine what kind of markets a trader is comfortable trading. There are two fundamentally different preferences for entering trades. The choice for a trader is between being a trend following trader, or a counter-trend trader.
Trend following traders are trying to catch relatively long term trends. In the above figure, there is a downward trend in the EUR/USD pair that lasts about two weeks. A trend following trader would enter on a certain technique when he sees the potential for a new relatively long lasting downtrend. In the above example, a trader opens a short position on Oct. 4th, and keeps the position open until there is a "go long" signal on the 15th.
Other traders try to trade consolidations or ranging markets. They do not adhere only to markets that are showing long term trends. Markets can go in three directions: up, down or sideways, and a counter-trend trader prefers to trade the back and forth movements of a sideways market.
In a ranging (sideways) market the counter-trend trader will try and "buy low, sell high" or "sell high and buy low". In the figure above, a trader would short the pair when it reaches certain high levels, and long the pair when it reaches certain low levels. The figure is a rough guideline of course, and a trader has to have a good feel and/or technical analysis to back up his or her prediction about the market’s behavior. A counter-trend trader relies heavily on support and resistance levels and should be prepared to trade against the recent trend if he or she believes there will be a pull back or retraction. Counter-trend traders will also have to be wary of price breakouts and a change to a trending market, which would put counter-trend trades in jeopardy.
Trend following traders are trying to buy the strength of the market while selling its weakness. Counter-trend traders try to “fade” the market by selling the strength and buying the weakness of the market. Of course, a trader could apply both aspects to his or her trading, but for the most part one is more comfortable trading one style over the other. It takes a different trading psychology to be able to place orders against the current trend because one believes there will be a retraction, than to trade a long term uptrend. However, since markets spend one third of their time in sideways trends, one may have to sometimes be a counter-trend trader; the alternative is to sit out and wait until there is another trend. To improve a trading methodology, one must decide what kind of trading style fits him or her, depending on psychology and what kind of market conditions the trader is comfortable trading.
The next step to developing a trading methodology is for a trader to select the tools that he or she will be using for entering and exiting trades. If a trader will be using technical analysis he or she can use trendlines, support and resistance levels, fibonacci levels, and technical indicators. Based on those tools, a trader then creates a trading plan. The plan’s main features are what signals one is looking for in order to enter and exit a trade. A trader using fundamental analysis will also have to come up with a trading plan which would include what economic indicators the trader will be tracking, along with the conditions he or she is looking for in order to enter and exit a trade.
This lesson’s purpose is not to outline what signals to use to create a trading plan; that is up to the individual trader. There are many resources that one could find, including on this website, that give some guidance on using technical and fundamental analysis to create a trading plan.
Once a new trader has laid out some guidelines on how they will enter and exit trades, it is very prudent to trade on a demo to build up experience, before opening a live account. It is important for a plan to be able to weather market moves that are relatively unexpected; therefore a trading approach should factor in market noise. With a demo account, a trader can train oneself psychologically, in exercising discipline and sticking to a trading plan. Once a trader achieves consistent success on a demo then it may be time to move to live trading. There will be a learning curve with live trading compared to demo trading as conditions are slightly different, and since real money is on the line, a trader’s emotions will come into play.
Risk Management Techniques
This is something a new trader may not want to hear, but an important psychological part of trading Forex is to understand that unless a trader has a big enough account to weather adverse market moves, the capital in one’s account should be considered risk capital. Forex is not the same as other investments since traders, depending on one’s leverage options, can and should be ready to lose all the capital in his or her account. Of course, in reality a trading plan is designed to do just the opposite, not to lose money. When beginning a trading plan, another step for a trader is to determine the psychological level of drawdown on the account that one is willing to tolerate.
An aggressive trader may be willing to take on bigger risk to potentially get a larger reward. For example, he or she may be ready to face a drawdown level of 50% of the capital in an account in order to try and achieve certain results. A conservative trader on the other hand may only be willing to get a smaller reward but will risk, for example, only 10% of the account. These numbers are not meant to be taken literally, they are just used here to highlight that some traders may have a bigger appetite for risk while others are more conservative.
Why is the topic of potential drawdown being discussed? It should be understood that if one’s trading is generating losses, instead of returns, and the account is approaching a trader’s maximum drawdown level, it means that something is wrong with the trading approach or tools. It may be time to stop trading and re-evaluate the analysis that the trader is using.
It is perfectly normal to lose on any particular trade, but it is a serious warning when there are consecutive losses and the losses add up to a large part of a trader’s account. Small losses are part of the trading plan, as some positions will end as losers and others will be winners; what is important is to have an average between the two that is positive. This means that the winners are bigger than the losers and an account is building equity.
A trader’s maximum operational drawdown is linked to the money management technique: per trade exposure. Per trade exposure is a technique in which there is a certain amount of capital that a trader is willing to allocate per trade. This means that there is a certain amount of risk per trade that the trader is willing to assume.
Many new traders think that if they see a potential trade, they can risk a substantial part of their capital to get a large return. One of the recipes to disaster or failure in trading is when a beginner trader tries to get rich quick; to make a fortune with one or two trades. One should aim to trade with consistency, and on average win more than you lose.
Let’s say that a trader, has a $10,000 dollar account and wants to allocate 5% of his account per trade. This means the trader is willing to risk losing $500 on any one trade. If a position goes against him by 5% of his account then according to his per trade exposure he should close it. When a trader has a specific per trade exposure amount it forces him or her to use discipline, limiting the effect of emotions on trading decisions.
Again, the numbers that are being used here are strictly to build an example and should not be used literally. If one is unsure what amount to allocate per trade, they should seek the advice and guidance of a financial advisor.
In another example, it is Oct. 12th and I am a trend follower. I want to enter on currency strength when I see a new uptrend forming as price approaches a new high at 1.2575.
Let's assume that from looking at support levels beforehand I made the conclusion to place my stop somewhere around 1.2480, which is a difference of around 100 pips.
If I have a $20,000 account and my exposure per trade is 5%, I can risk $1000 on a given trade. If I prefer to open 1 Lot positions, the 100 pip difference from where I want to open my trade to the stop fits with my 5% requirement. Therefore, the amount from 1.2575 to 1.2480 is now considered my risk after opening the position.
As long as price stays within the 100 pip risk zone, it will be considered noise. If the pair moves to 1.2480, my original analysis was wrong and the stop loss order I placed earlier should close my position.
How to size one's position ties into exposure per trade and will be discussed on the next page, along with what happens next to the "new uptrend".
Using Exposure Per Trade in Examples
Our lesson continues with the exposure per trade example from the previous page.
After opening the trade on October 13th based on a certain analysis and technical picture, price breaks in the opposite direction!
Traders that use risk management techniques such as exposure per trade, are less likely to close a position at the first instance of the market swinging against them.
A trader with a risk management plan is not as easily affected by fear because he has already determined when he would exit the position if the market continues to move in the wrong direction. Therefore, the price movement after the position is open (3) is considered noise. With this trading strategy in place the trader would be able to gain once the market turned back up. Fortunately for the trader, the market changed direction at an opportune moment as the stop was very close to being activated. However, if price did not turn around and kept heading downward, the trader would close the position once his maximum risk level for any particular trade was reached.
In another scenario, a trader wants to enter when the market breaks the (1) high, and also establishes a stop at 1.2480. The next time that price breaks 1.2575 is on October 19th.
Let's first look at a trader that has a $20,000 account and is willing to risk 5%, or $1,000, as his exposure per trade. Since the stop is 100 pips away, or $1,000 away on a standard 1 Lot, he would take out a 1 Lot position. With this size trade, if the market moves against him and the position gets stopped out, he would have lost only 5% of equity as planned.
If there was a similar trader that chose 5% as her exposure per trade and had the same stop, but had $10,000 in her account then a 1 Lot position would not work for her. If she was to open a 1 Lot trade, and her stop was reached, she would lose 10% of her account, not 5%. Therefore, the proper size for her risk threshold would be a position that is 5 mini-lots or .5 standard Lots.
Let's go back to the trader from our first example (from previous page), but now he does not place a trade on October 13th.
After there is a new bottom on the 14th, and the currency starts to show strength again, this trader wants to enter when a new high at 1.2520 (5) is broken. He will get that chance either on the 15th or the 18th. Entering at this level, while having the same stop means the trader can take on a bigger position as the amount of pips to get to the stop (risk) is now smaller by about half.
For a $20,000 dollar account, with a 5% risk per trade threshold, the position can be 2.5 Lots. An adverse move to reach the stop is around 40 pips, which is equivalent to $400 for 1 Lot. Since the trader has $1000 to risk on this trade, he divides $1,000 (exposure per trade) by $400 (possible loss for 1 Lot) to get the number of Lots he would take out for this position. For example, a 1 Lot position, when the stop is reached would have used 2% of equity (20,000/400=.02). For a 2 Lot position the stop would be activated at 4% of equity. The trade size that fits the trader's exposure per trade is 2.5 Lots.
In the same scenario, for a trader with $10,000 in her account and 5% as a chosen exposure per trade, the position she would open would be 1.25 Lots. The number is calculated by dividing her exposure per trade, $500, by the possible loss for a 1 lot trade to the stop, $400.
Therefore, $500/$400 = 1.25 Lots.
There is a lot to learn about position and money management. The ideas presented here are a very basic primer and it is recommended that you study trading psychology and proper risk management to improve your chances of surviving in the Forex market.
Now, we will continue our lesson by presenting some more basic concepts.
Psychology of Trading
Having Flexibility in Trading Strategies
A trader should have some general flexibility in his or her approach in building equity depending on his or her successes and failures. Basically, there are several different approaches to sizing a position depending on total equity. There are sophisticated approaches and simple approaches. The simplest way is to use a percent of one's equity, like in the examples from the previous page. If a trader has a winning streak, so trade by trade equity grows, then he or she can increase the size of their positions. It is better to build up equity and to trade within the means of your account instead of over-leveraging (taking too big a position) and losing huge amounts on a bad trade. With each loss the size of the next position decreases and each subsequent trade decreases the overall exposure to risk.
It is well known that markets are changing all the time; therefore a trader will have times when he or she re-evaluates their trading plan depending on market conditions. A trading strategy does not have to be set in stone; the more flexible and robust it is, the better. There is a trap however, as some new traders change their trading plans trade by trade, depending on very short term conditions. This can lead to bad results. If a trader feel the necessity to do so, there is probably something wrong with the very core of his or her trading approach.
To repeat this point, the fundamentals of a trading plan should be robust. That means that a trading plan can withstand changes in market conditions and has some flexibility, but that a trader does not have the need to re-evaluate his or her trading plan on a trade to trade basis.
Psychology of Trading - Mastering Emotions with a Trading Plan
We have already mentioned some aspects that deal with the psychology of trading in this lesson, and its time to expand on that.
The market is governed by four basic human emotions: fear, greed, euphoria and desperation. These emotions and how they play out are shown on the charts. Extreme levels, such as panic selling or a torrid uptrend are associated with those emotions. A trading plan is created to manage a trader’s emotions.
Since all traders are people it is understandable that we will have emotional responses to trades. When the market moves with someone, they may feel happy and if it does not, some people may get mad or depressed. The reason that traders have trading plans is to try and anticipate their actions before they even place a trade. In other words, before each trade a trader should sit down and write the steps he or she will take depending on hypothetical changes in the market. These steps would take into account the potential good and bad scenarios. When a trader is already holding an open position it can be hard to think clearly as to what to do next, as emotions may cloud one’s judgment. When one has predetermined guidelines beforehand - a trading plan - it works as an aid in taking emotions out of trading.
There is a potential threat to one's trading if one is not disciplined and does not follow his or her plan. Many new traders fail because they create a plan but then they don’t follow it, because they are emotional and make exceptions. They think, "just for this trade I'm not going to follow my plan because I know the market is going to change in my favor." This can be a recipe for disaster. A trader should not change his or her plan unless they sit down and re-evaluate their whole trading strategy. If the trader comes up with a better plan, then he or she needs to exercise discipline in sticking to it.
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A Trader’s Journal
In order to maintain a trading plan it is very important to create and keep a trading log. In it, a trader keeps notes and information about each trade they execute.
The main pieces of information one needs to record in the journal are a time stamp of the trade, what was the position (currency pair and size), and direction. Then one should include a brief description of the reason that the trade was opened. The main tools that one uses should already be described within a trading plan, and in the trader's journal a trader is noting which tools out of the trading plan he or she is using for this trade.
Let's say a trader is using triple moving average crossovers to generate trading signals. When the trading plan produces a sell signal he would record in his trading journal that he entered a trade on a certain pair, EUR/USD, short at price 1.2510 because of a bearish crossover and he is waiting for a bullish crossover to appear in order to close the position. A note on how much risk one is willing to tolerate if the pair heads in the opposite direction should also be present.
If a trader lacks discipline in implementing his or her trading strategy there is a chance that he or she may exit a position too early. If something unexpected happens and a position starts going negative, a trader may start feeling the emotion of fear and close the position prematurely only to watch it take off afterwards. This is a very frustrating experience.
Another bad scenario is one in which a trader does not exit his or her position at a predetermined exit signal, because the trader cherry picked the trade and thinks it will continue to go higher. Even though the initial analysis was correct and the position reached its profit level, the market may turn in the opposite direction and go against the trader. Since this trade was a winner before, one may get greedy and decide to wait until it gets back to its previous point. If the position goes substantially against the trader, he or she may find themselves with a losing trade when it should have been a winner.
Trades that go for losses and times when one does not follow his or her trading plan are two of the most important things that a trader should record in a trader’s journal. Until a trader masters his or her emotions, it will be difficult to think clearly when trading. But, if one reports what happened, later on he or she can go back and sit down and analyze what went wrong and try to get some positive experience out of what happened. The trader has already paid for this lesson that the market gave; so its good to now learn from it.
As a beginning trader one has to evaluate each losing trade. One has to sit down and try to understand why that trade turned negative. Was it emotions? Did the trader not accurately follow his or her trading plan for that trade? Or, was it one of those negative trades that is a normal part of a trading approach? Answering these questions will help one to better control oneself with each successive trade and put one on the path to planning for long term survival in the Forex market.