Forex: Trusting Probabilities and Mastering Psychology


Introduction

Traders, and especially new traders, seem to not grasp the fact that trading currencies is a
game of numbers and where mastering the psychological states are essential to good trading.
Even seasoned traders with an excellent track record seem to forget the law of numbers and
give no thought to the psychological aspects of trading.
Traders who understand the law of large numbers, make it work for them to benefit their
trading strategies and ultimately their profitability.

The Law of Large Numbers

The law of large numbers states that if the probability of something to happen is X%, the result
will approach closer and closer to that probability the more attempts are made.

Take a small test:

A coin will be flipped 100 times. With each tale, you will win R0.50 and with each head you
forfeit R0.25. (Flipping a coin has a 50% of landing on tales)
Would you participate in this adventure?
If not, then you are no trader / entrepreneur and can only operate in the safety and comfort of
a steady job – you are overly risk averse. The trader with an appetite for risk on the other hand
has an expectant return of: Profit = 100*(0.5*50 – 0.5*25) = 100 * 12.5 = R1250

In the given example above, the AVERAGE profit is R12.50 per flip. But that does not mean that
R12.50 will be made with each flip. The trader could lose on 10 flips in a row, which might
shaken his / her confidence, but this losing streak will NOT change the expected profit of the
game in the long run.

The lesson from this small test is that with each coin flip, EDGE will emerge to produce a net
winner. The trader needs to internalize and accept uncertainty: the result of one trade is not
guaranteed, not even for the best trader in the world. The trader needs to preset conditions to
exit losing trades to be able to trade again and again. This also means that not every trade will
stretch to 1 000 pips and the trader will need some way to estimate where to exit from a trade.
To take probability even further, a compromise between Stop Loss and Take Profit levels are
required as distance from the starting point. A target of 500 pips will not be obtained regularly
and there should be “breathing space” for price movement. Price movement will ultimately hit
your Stop Loss, and if to wide large losses will be suffered.

To have more winners than losers in trading requires everything….. chart analysis,
understanding market momentum and mood, macro analysis, risk and money management.

THE item that that makes all of this possible: emotional control and clarity of mind. The trader
must find a system or strategy and stick to it at all times.

Trading Psychology

Looking at a trading chart the trader has to realize that the chart has no feelings and neither
does the chart care about the trader. The currency market is driven by a mixture of
fundamental forces and the aggregate “belief” of the market participants. The market
participants are humans and computer programs developed by humans. The interpretation of
the market may be polluted by wishful thinking, reality check problems and a variety of other
human emotions.

In trading, the majority of participants are doing the wrong things or following incorrect
actions. That is why there are so many traders in the market losing money. Some of these items
include the setting of to tight stops or no stops at all, using to high leverage, chasing the
market, not able to “see” clear trade setups, using items such as “head and shoulders” as
magical formulae and trading with technical indicators as if the indicators will accurately predict
the future. It is not wrong to use these items, but only in a responsible manner. These items do
not provide the trader with an edge – nearly everybody else utilize them. What is required is a
deeper understanding of the market and to not fall victim to the psychological traps of denial,
avoidance, cognitive capture / information bias, fear, greed and other mental toxins providing a
distorted reality. The trader must be able to look at the chart without wanting to see a buy or
sell opportunity. Just notice “WHAT IS”. Ask if recent candlestick patterns are convincing? Is this
part of the bigger picture or is something seen which looks bigger than it really is? Look at the
15 minute chart and be convinced that the price can’t go higher while reality is a 5 year low.

What is required from the trader is to understand and trust large number probabilities, keep
losses small in relation to profits, avoid setting stop losses to tight, find a system with a small
edge that would suit a particular trading personality, aim for an 80% win rate and a 20% loss
rate, look at the market without emotions, ego, psychology and manage stress. This way the
trader can enjoy process without ever stop learning. No trader can stop learning, reading,
working on self, strategies and understanding the market.

Conclusion

The aforementioned discussion is all good, neat and well, but also need to be put in practice
and practically applied.

One of the best suggestions to approach the market without fear, misgivings or greed is to have
a well-documented trading plan. A trading plan that sets out the traders’ goals which starts
from the ideal situation to be achieved and cascaded down to practical small units to be
achieved. In addition to the personal goals to be achieved, the actual strategy on the currency
pairs to be traded must be included. This strategy will spell out which currency pairs will be
followed, the type of analysis (fundamental versus technical), which indicators will be used, the
time scale, on which circumstances will entry and exit points be based, the leverage, risk and money management. These rules need to be followed very meticulously and record must be
kept in a disciplined manner.

Utilizing a trading plan should be the only routine that need to be followed during the trading.
It should be followed religiously and the results recorded. The trading plan need to be analyzed
and the trader must learn from mistakes. Mistakes must be used to tweak the trading plan to
better the plan. The habit to follow the trading should be reinforced with a positive mindset
and on a conscience the trader must address any and all psychological issues.

With the trading is it possible for the trader to act without emotions and see what the factual
situation on the chart is. By repeating the trading plan over and over (big number probability)
the trader will become profitable in the long run. By repeating the trading over and over the
trader will overcome psychological attachments fear, greed, anxiety elation and any other
human instinct or emotion which could have a negative impact on profitability.

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