Why Most Forex Traders Fail: Do You Have What It Takes?
Updated: May 16, 2013 at 8:10 AM
Forex trading just like any trading is a lot about psychology. Do you know the most common pitfalls among failing forex traders? Do you have what it takes to become a successful forex trader? This is our most comprehensive article in our trading psychology section where we'll go through both psychological reasons for failing but also some other important reasons. Hope you'll both enjoy and learn from it.
First the psychological reasons
After going to the trouble of developing and implementing a trading plan, why would a forex trader ever begin breaking their own trading rules?
Each individual trader will have a different answer to the above question. In many cases, inexperience is the first culprit. "Rules are meant to be broken" simply does not apply when trading in volatile market environments, as many a forex trader can attest. Unfortunately, many trading novices seem to choose especially volatile times to break their own rules, just when they should not.
A series of other reasons typically arises for more experienced traders, but whatever the cause, losing discipline with one's own rules can often lead to a trading blow-out. This can put the trader firmly out of business regardless of their previous trading success and experience.
One of the pitfalls of not having a trading strategy or ignoring a well-developed one is following your emotions when making trades. Fear, along with greed and hope are the main trading emotions that make the forex market move. Because of the inherent fear of losing money that affects everyone involved in the forex market, fear could be considered the market's number one emotion.
In general, the emotion of fear arises from a perceived threat and developed as a natural defense mechanism in most animals. The limbic brain, which makes up the most primitive and reptilian part of the brain, controls fear which originally took the form of the "fight or flight" self-preservation response characteristic in all higher animals.
While losing money is the apparent cause for fear, the root cause is a fear of poverty; no one wants to be poor. The fear of poverty is another deep-seated fear that society has programmed into its members and directly affects the trading community.
A Forex Trader's Fear Responses
Several types of fear arise often in the course of trading whether consciously or unconsciously, these emotional responses include:
• The fear of failure
• The fear of missing out on potential profits
• The fear of losing everything or impending doom
The fear-based emotional responses cited above find their expression daily in the markets and often contribute to trading losses unless appropriately managed. Nevertheless, fear can be extremely useful in the event of calling the market wrong, as W.D. Gann, a well known trader from the last century noted "Fear will often save you if you act quickly when you see that you are wrong."
Many professional traders will admit to allowing the gut feeling of fear to give them an indication as to the right time to get out of a trade. This applies to situations where the trader is either taking a profit or cutting losses short. Another Gann quote on fear sums it up nicely: "The fear of the market is the beginning of wisdom."
How Fear Manifests in Forex Trading
Having a great trading system and all of the technical and analytical tools for success in trading will not suffice to be successful; a trader has to have the right mindset. This can only be accomplished by learning to control emotional responses when trading and in all trading situations.
An emotional response which can adversely affect a forex trader involves fear impeding the trader from taking action. This can be especially damaging if the trader has a losing position and finds themselves paralyzed while the market continues moving against them.
This type of response may also impede a trader from taking advantage of a trading opportunity going against their own trading plan and allowing fear to prevail over their own instructions.
Another instance of fear which arises during forex trading tends to happen after the trader has made a losing trade. Because of a lack of confidence caused by the previous losing trade, the forex trader might be too afraid to jump back in regardless of an opportunity to make back the money lost on the losing trade.
Fear will also cause a person to exit a profitable position earlier than would be necessary. This reduces potential gains and makes you unable to absorb inevitable losses longer. It is important to be able to absorb these losses long enough for your gains to outweigh them.
The fear of loss makes up a chief component of the forex market's mass psychology, and it can lead to major market panics as people scramble to get out of positions at almost any price.
Dealing With Fear When Trading Forex
Basically, when dealing with fear, keep in mind that fear relates almost exclusively to future events. This could take the form of prolonging an unacceptable situation or of making a present situation worse.
A good way to deal constructively with fear is using fear to replace hope which can be extremely detrimental to a trader. For example, instead of thinking, "I hope the market will come back," you can replace that thought with the much more helpful, "I'm afraid I'll lose more money." This thought replacement technique also aptly illustrates the dilemma that a forex trader faces when they have made a losing trade.
Basically, if you can be disciplined and able to trade with a sound trading and money management system, fear and other emotions can easily be controlled. As long as you "plan your trade and trade your plan," fear can usually be kept at a minimum in your forex trading.
Like fear, the emotion of greed is common throughout the forex market, and it basically is the excessive desire for more than you need.
In many cases, greed can manifest in the common trading errors of overtrading and running winning trades into losers.
Greed can also cause a person to stay in a losing position beyond the time when an objective trading strategy would call for an exit. This obviously results in a larger loss which then ultimately exhausts your capital.
Most people do not have any idea of how greedy they really are until after they start trading. Having a clear profit taking component of your trading plan can help overcome this emotional obstacle to success.
Hope can be one of the most damaging market emotions to a forex trader's success because hope can coddle a forex trader into holding onto a losing position in the hopes that the market will come back.
The market has already proven the trader wrong, but hope makes them stick with the losing trade, often leading to disastrous results for their trading portfolio.
In fact, the hopeful trader would be far more reasonable in fearing losing more money on a losing trade.
Nevertheless, hope can be used constructively by traders when they hope to make more money on a winning trade and therefore let their profits run on.
Letting the emotions of greed, fear and hope dictate your trading activity is one of the major reasons why most forex traders fail.
The emotion of excitement can often arise after a trader has made a winning trade or when the market moves sharply when a trader has a position causing a burst of adrenalin.
At this point, the trader needs to remember in the heat of that excited moment, that their success in trading over the long run will be determined by how disciplined they are in following their trading plan.
Elation will generally arise when the trader has made an impressive unrealized profit on a position. The boost to their confidence may lead them to think they can do no wrong, and that can be when the problems start.
Not only does the elated trader need to take their profits out of the market by liquidating the trade and realizing their profit, but they also need to stick to their trade plan in doing so.
Nevertheless, the elated trader may throw caution to the wind and disregard the profit taking portion of their trading plan. This can even have the unfortunate result of them frittering away the handsome profit they had originally seen on the trade.
Remember, you cannot take unrealized profits to the bank. Realizing profits in a disciplined way is an essential part of trading successfully.
Lack of Discipline
Lack of discipline leads to emotional trading and is another of the major reasons why most forex traders fail. Losing discipline in a trading situation takes place every day in the market, and any of a number of causes and excuses are used by traders to justify their mistakes. Unfortunately, more often than not, a trader that loses discipline will eventually lose money as well. That is, unless they are extremely lucky, of course. Still, the fact remains that they are just not playing the odds when it comes to their forex trading activities.
At a certain point, the trader who has lost all discipline acts in a way remarkably reminiscent of a gambler, since they have virtually stopped being a business person when it comes to their trading.
Such a gambler might get favored with a long string of winners, only to gamble away all of their winnings and more before leaving the table. Of course, they had ample opportunity to walk away with a profit, but they did not have the discipline to do so.
In essence, any forex trader that wants to be in the business over the long term needs to think of their trading activities more as a business, than as a gambling game.
Basically, having and implementing a trading plan makes up the trader's method for minimizing emotional reactions while trading. Having a set of rules which are of a purely technical nature, is the ideal method for approaching forex trading in an objective manner.
Having a solid trading plan and the discipline to follow it can minimize losers while maximizing winners. Because of the variety of situations which can arise in the course of trading, a trader is well advised to include every possible trading scenario that can occur in their trading plan.
Once you've developed an objective trading strategy or system, you must follow it! In developing your system prior to your first trade, nothing is at risk. For this reason, you should be able to develop a trading strategy that is objective. Once you've started trading, risk and reward become reality and you can get carried away by your emotions. Adhering to your objective strategy through self discipline is the only way to avoid this problem.
Other reasons why forex traders fail
Not entering a stop-loss order
An example of an easily avoided mistake which tends to be made often involves not entering a stop-loss order immediately after entering into a position. Some traders that trade forex without stop-loss orders can see their accounts wiped-out on just one all too common currency spike.
Trading without a reasonable risk assessment and management strategy can spell disaster in the highly leveraged game of the forex market. With leverage ratios of up to 500:1 for some accounts, a large sum of money can evaporate in what seems like an instant. In the U.S. the maximum leverage is 50:1 for majors and 20:1 for minors.
Purposely trading without a stop-loss and prolonging a losing position can arise from the trader's perception that the market will turn around if only they are patient, which may or may not ever happen. Basically, the trader has already psychologically placed themselves at a disadvantage.
An initially small loss can often begin to grow, weighing on the mental state of the trader "riding it out". They are now stressing over the growing amount of the loss as the account is put at risk. The trader eventually chokes on the growing loss and closes out the position near its worst point, only to see the market subsequently recover. They are devastated and so is their trading account.
They then typically sit on the sidelines licking their emotional wounds and watching the market make an equally strong recovery. Unfortunately, this scenario plays itself out far too often among forex traders that do not manage their risk with discipline and according to a strict trading plan.
Lack of Capital
One guaranteed experience in the forex market is loss. If you are trading, you are guaranteed to lose on some of your trades. You need to have the capital to sustain those losses that will, at times, outweigh your gains. This problem becomes even worse when traders make up for their lack of capital by using heavy leverage. Of course, all forex trading relies on leverage, but try to grow your capital so that decreasing leverage is required, or so that you can maintain backup liquidity. Taking too much risk in a single trade often occurs in the increasingly slim hopes of making back the lost funds in a bigger loss, again when the trader cannot control their emotions.
Unrealistic Targets and Goals
Another reason why most forex traders fail is because they have established unrealistic targets and goals. These impractical goals will either cause a person to take more risk than they should on individual trades, or they will encourage more trades than would be necessary within the bounds of a balanced and objective trading strategy.
While taking on too much risk can prove disastrous to the forex trader, a high-risk aversion will limit a persons ability to take the necessary risks to be profitable and successful in the forex market. Forex market trading is not for the faint of heart!
Poor Choice of Broker
If the broker that you chose does not have the skills, knowledge, and tools necessary to properly advise the new forex trader, the possibility of failure increases significantly. Read reviews of the most reputable brokers out there.
Lack of Knowledge
Just as it is with any business, whether you are selling products or services, trading futures, or trading in the forex market, you need to know the business in order to be profitable. Find or buy a forex trading course from a trustworthy source, and work through it completely. This will give you the education you need to properly prepare your own trading strategy, evaluate potential brokers, and help you to avoid the common causes for failure mentioned above. After becoming familiar with the market, push yourself to improve and excel. Ultimately, failure happens because people never spend the time or effort to do well.
The Forex Trader's Solution
While eliminating the emotional element in trading is unlikely, the way emotional and character elements have been minimized by seasoned professionals, is by education, confidence and a trading plan.
Being well educated on the economic forces that cause prices to change and considerable familiarity with the financial product or commodity one is trading, give the trader confidence. Read our free forex course here.
Confidence in trading makes up a large part of a successful trader's attributes. Nevertheless, in order to be completely confident, a profitable trading plan which allows the trader a framework to trade upon is the other part of a successful trader's secrets. Learn to trade forex confidently for success.
The trader needs to strictly adhere to the trading parameters of a concise, complete and well-tested trading plan. Any such plan should contain a risk-management component and be relatively easy to follow and implement in practice.
As an additional measure of insurance, position sizing in decreasing amounts as the portfolio size decreases along with less frequency of trades and a focus on higher probability trades is recommended. Read more on forex position sizing strategies.
This helps add a further cushion to the portfolio in the event your system undergoes a string of losing trades in unfavorable market conditions. While such a strategy for handling a long string of losing trades will hopefully never be used by a trader, having one in the event this dismal scenario occurs is certainly preferable to not having one at all. Read here for information on how to design a forex trading plan and rules.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.