2. Major Barriers And Pitfalls

Stress and Distress

There is a difference between these similar psychological states and it's worth knowing it. Brett N. Steenbarger, before he displays some strategies to improve a trader's performance, explains in one of his articles:
 
During my career as a psychologist, I have worked with dozens of professional traders, watching them trade and helping them with their trading. Some of the traders I have worked with have been phenomenally successful, making millions of dollars a year. Others have struggled to achieve profitability. The one common element across the entire group is that they have been highly competitive and emotionally charged. I honestly cannot say that the large and successful traders were any less emotionally volatile and stressed than the new and small traders. Reading articles by trading psychologists, one sometimes gets the impression that successful traders achieve a kind of Zen-like control over their minds and feelings. I sincerely doubt that this is the case. As long as there is risk and uncertainty, stress is a normal, expectable human outcome.

Stress is built into trading. Our job is to ensure that it does not become distress.

 

Fear Of Success

As strange as it may sound this happens to traders once they achieve a certain degree of success. Either social pressure or educators force people to become high achievers. This inherited need to succeed at all costs makes trading more difficult. Being afraid to accept losses may lead a trader to let losing positions run to unsustainable levels. Or even worse, it may bring the trader to add to losses due to a lack of a proper money management.
 
Another sign of fear of success is doing extensive research on a currency pair, preparing one position exhaustively and yet lacking the confidence to put the plan into practice.
 
And another one: not acknowledging what type of money management is best suited for the trader's personality. Especially during a winning streak, the fear of success may lead the trader to cut the position size instead of pursuing the potential of an eventual larger win streak. There is nothing wrong with managing your position size accordingly to your comfort zone or even exceeding it a bit, but this decision should be based on the recognition of the boundaries of your comfort zone and not due to fear.
 

What Can I Do If I Fear Success?

First of all, try to figure out if this is your problem. Ask yourself if if you feel the need to win at all costs; if you are afraid of looking like a loser (maybe in front of your friends or relatives); or if you have been taught to be a winner. The sentiments developed from these situations will give you a clue if you need to work on this aspect.

If your answer is yes, then try to swift away from looking at the Return Rate and Win Ratio, and focus more on figures like Profit Factor, Payoff Ratio, Expectancy (see Chapter C02) and with measures of the Equity Curve (see Assessment C02 of the Practice Chapter C). The statistics will bring your focus to the technical side of trading and help abandon the fixation on the money.

A trade resulting in a loss is not necessarily caused by a bad fill from your broker of by listening to the media, so take responsibility of your actions and accept the fact that markets move in unpredictable ways sometimes. If you have a hard time accepting changes in the market, examine your method and its flexibility to cover those contingencies- this goes from system's rules to risk control and position sizing.

 

Opportunity Cost

You might think that if you don't trade you don't lose. Well, that is not really the case. Hesitation and failure to execute a planned trade involves a cost as well, just like tying capital to a losing position. This cost is called “opportunity cost” and is the result of a bad habit, that of ignoring your system's signals and letting a position enter negative territory after a favorable excursion.
Here again, a statistical trackrecord of your system is key to trade decisively because it shows you the flaws and edges of your trading style and system.
 
Thinking statistically will combat that need to succeed because your goal will be redirected to collect data for your trackrecord. The more trades you add to your trackrecord, the more you see your wining and losing trades building a smooth equity curve. Besides, the more you trade, the more accustomed you become to taking a loss.
 

Fear of Loss

If you start to second guess your analysis, you end up avoiding many trades. Caution is good up to a certain measurem but being overly cautious can lead to a spiral of hesitation and loss of confidence.
 
Fear in the form of self-doubt and anxiety stem, partly, from not knowing your system well enough. If your trackrecord shows a maximum Drawdown of 20% and a current string of losses brings the equity down by 10%, you should feel confident that the equity curve will recover. Just make sure that other statistical figures are not printing records. If that is the case, revise your rules and try to detect the source of the current Drawdown.
 
Fear of loss can also manifest in the incapacity to define risk levels. This can lead to avoid setting a stop (of any kind, see Chapter C01), or trailing the stops too close to the current rate, increasing the probability of a stop out.
 
Another situation resulting from this fear is the inability to cut the losses short. Do not go overboard when cutting losses: if you over leverage and use tight stops to limit your risk, you are going to be stopped out very frequently.
 

Hesitation

Hesitation, as you see, can stem from such disparate aspects as fear of success and fear of loss, and these, in turn, may also have different roots in your belief system. That is why there is no sure remedy to common psychological barriers- you have to gain awareness of their origin.
 

What can I do when hesitating?

A trader can hesitate on entries, on exits, or on both. If you hesitate on an entry, fist of all be sure the signal follows your rules and nothing else. If you still hesitate, ask yourself if you have been over-analyzing the chart or if it is a gut feeling. Do not ignore your intuition- it should be cultivated along with your other skills.

If the exit is what makes you hesitate, try using stop losses. Yes, this is an easy answer, but there are many types of stops (see Chapter C01). If you place a stop order with your broker, the sell decision is done and will be triggered in due time. The other way is, for instance, to go back in history and see what is the Maximum Favorable and Maximum Adverse Excursion in your trades. By collecting these data you can build a mean to guide you in future stops and take profits.

Review the mechanics of a trade (stop loss points, price targets, support and resistance zones) instead of dwelling on feelings or emotions.
 

Unintended consequences

One major barrier to our evolutions as traders is the inability to consider that our actions have both intended as well as unintended consequences. This leads to underestimate the consequences and overestimate the motives. The most common among beginners is to consider only the earning potential of a trade, without accepting the possibility that this action will result in a loss. Despite knowing that every entry can lead to a loss, in most cases this possibility isn't really contemplated in the method, the result being much more painful.
 

When Emotions Rule

Think of the last time you entered a trade risking way too much either because you were mad at the world after a series of bad losses, or just feeling invincible after a win streak. Extreme emotions like recklessness or euphoria can have their origins in the beliefs mentioned above. You may think after a series of losses: “The market will do what it wants and it is unforeseeable anyway, so why bother estimating it?” or “This trend has lasted too long, it's time to reverse and I'll be the first to profit from it!”. Be attentive to these kinds of thoughts arising to your conscious mind. You have to learn to know well your mind and thoughts and control them as much as you can.
 

Projecting A Personal View On The Market

This topic is about expecting a certain pattern while the market is exhibiting a completely different one. The most common one is probably trend direction. We know from the Elliot Wave Theory (see Chapter B03 or Practice B Extra Contents) that traders rarely acknowledge the start of a trend. If you see a chart with five waves going down and three going up, and then again five waves going down and three going up, five down and three up, and one last time five down and then suddenly five waves up, your mind will see in it an opportunity to sell again at a great reversal. And like you, many traders will not recognize that the rally had impulsive qualities, something evident even for those who are not familiarized with the Elliott Wave Theory. Only very few traders will be able to think differently of the crowd- that is one of the major reasons why markets trend.
 

Fear And Greed

This topic could be extended endlessly as these are the most often experienced feelings in trading. We prefer to state that fear causes you to not do what you should do because you frighten yourself out of trades that are winners in deference to trades that lose or go nowhere. Succinctly stated, greed causes you to do what we should not do, fear causes us to not do what we should do.
 
Yes, an edge can be of psychological nature as well. Take note of this one and see if it applies to you: the more frightened you are of taking a trade the greater the probabilities are it will be a winning trade. From previous lessons about price action, you will understand it well.

 

Inconsistency

Especially when traders adhere to the Holy Grain belief, they become involved in an eternal quest for the perfect system or indicator. This will lead the trader to switch rules and change parameters or tools every time a string of losses occurs. If you follow a system for some time and later abandon it, then there is no reason to follow a system at all.
 
If your system signals an entry point, do you feel the need to verify that signal with other tools? Or even worse, do you feel the need to find an argument that invalidates your signal, for fear of losing the deal? Be aware that adding unknown variables to your method can be a result of lack of understanding of the true concept you are capitalizing on.
 

Overconfidence

This happens when the trader overestimates his/her ability to predict future price action. Especially new traders feel they can beat professionals with simple strategies. Overconfidence usually doesn't last long. Did you notice how the market shakes off the majority of traders before it moves in the most probable direction? Take note of the following axiom: The market often moves in the direction that will inflict the most pain on the greatest number of traders. An explanation of why it happens you can find it in the extra contents of Practice Chapter B.
 
Acquaint yourself with the way market professionals trade, paying special attention to price action (see Chapter A04), and build a plan to take advantage of the price action that normally takes your money from you.
 

The Market Is Not After Your Money

If you practice strict money management and don’t over-leverage your account, the market will not be able to take your money. But here is the catch: if the market cannot take your money by you over-leveraging your account, it will try to take it from you in the form of emotional losses.
 
Although the market seems to confuse most participants most of the time with its swings and reversals, in reality there is no market going after your money or after your emotions. Therefore, don’t take it personally if you are the victim of an adverse price move. The market is not after your money but is just a reflection of a crowd behavior, and your position just happens to be carried along with it.
 

Underestimating Unanticipated Risks

Many traders completely ignore or do not consider those risks which are less frequent but equally important such as connectivity issues, price gaps, technical glitches or even a perverse use of technology (abusive slippage, for example). For a complete section on risks, please refer to Chapter C03.
 
In trading, you can never have complete knowledge or total control of the markets and its associated risks. You are always exposed to that proverbial "black swan," or that unpredictable event that defies prediction.
 

Changing Market Conditions

Part of your Trading Plan should consider the likelihood and severity of extreme occurrences, or structural changes in the markets. A model based on the concept of accumulation of interest rate differentials (the so called “Carry Trade”), should consider the fact that the differential between interest rates may disappear or be reduced to a value that overrides the model.
 
The Education Section at FXStreet.com helps you stay informed about market regulations and how they can affect your bottom line. Check this section regularly to stay informed about major changes in the market place.

Ignoring Position Sizing

This pitfall starts from a lack in understanding the concepts of leverage, margin, and not implementing a risk control and a money management model into your system. Traders usually are more focused on capital appreciation than capital preservation. But if the second isn't fulfilled, the first is unattainable.
 
Size influences your objectivity, and most people react differently when they're under pressure from being over-leveraged. They tend to be more emotional or reactive.
 

Laziness

Signal providers and newsletters know how to exploit lazy traders. After all, it seems easier to purchase an analysis service or a signal software than to scan the charts on a daily or weekly basis. This is not to say you can't complement your analysis with such services, something which is highly recommended especially if you are starting out. The problem is when the trader searches for substitutes to hide a lack of commitment.
 

Over-analyzing

Over-analyzing can lead the trader to search for causes or effects where none exist. Naturally, there's always a reason why a price moves, but it doesn't mean it is a recurring motif. It can be an isolated case. Surprises and improbable events happen the longer the trader is in the market. Viewed from a probabilistic standpoint, the more time an unlikely event has to manifest, the greater the odds that the event happens. So be prepared to experience a lot of surprises throughout your career as a trader.
 

Wrong Estimations Of Cause-Effect

To think that one effect has a cause of the same dimensions is another typical pitfall. For example, a very sharp movement in price action may not have much of an explanation. It could be enough that the market is less liquid and a major participant executes a position to make the price hit a new high or break out of a consolidation.
 
Attributing an effect to a single cause when in fact there may be multiple causes to this effect is another inability to estimate cause-effect relations.Taking a correlation for a cause is a typical pitfall. For example: if the Gold prices rise, the USD has to fall. If there are times when such a correlation is evident, it does not mean that a movement in Gold (a cause) will produce a movement in the USD (an effect).
 
Some traders establish a cause-effect relation from a single example, which means the inability to consider information or evidence of what may be veritable causes of other examples. In system development, we have talked extensively about how to measure and verify a hypothesis (see Chapter C01).
Many times we look at moving averages and we think a cross between them will cause a movement in the price. It is actually the reverse: the crossing is showing something that happened in the price. When developing a trading system we have seen how a system starts with a concept, and how the basis of this conceptualization is to understand what causes the movement on which we intend to capitalize.
 
Not understanding the cause of the desired effects is another variant of a cause-effect misunderstanding. By focusing attention on the signals emitted by an indicator, for example, we fail to see what the indicator is interpreting in terms of price action. Joseph Trevisani sheds some light on the subject:
 
Technical analysis does not produce price movement. I state the obvious because in the endless attribution of trading cause and effect to ‘the market’ it is easy to lose sight of the actual composition of the market--thousands of individual decision makers. The translation mechanism for technical analysis runs from the information contained in a chart through the assessment of that information by market participants to the trading behavior of those individual market participants.

[...] if every market participant is attempting to do the same thing, namely wring trading profits from the day’s activities, how do they all go about it?

The first thing every trader does, in New York, Tokyo, London and in every land in between is to pull up charts and look for trading opportunities. Every trader looking for profit is judging the same charts. Everyone sees the same price history, and everyone identifies the same potentially profitable chart formations. And, in the absence of other factors, the majority of traders will come to the same trading conclusion based on the observed chart formations.

[...] There is powerful self-fulfilling logic in technical analysis. It works, because everyone trading believes it will work and makes their trading decisions accordingly. For a retail trader this knowledge is the most accessible and effective trading strategy that exists.

Hypothetical Or Past Results

This aspect is derived from the previous one. When assessing a system, it is important to question why the result was a given one, what conditions should lead to identical future results, and what variables might change. The warning which dictates that past results are no guarantee of future results remains clouded by the belief that a system can reveal the supposedly orderly market functioning.
 

Lack Of Statistical Thinking

Traders show a lack of statistical thinking when they isolate the trading results and show an inability to consider their relations and magnitudes. In most cases, this derives from the inability to use basic arithmetic calculations and know how to quantify the results. The consequences are evident in the inability to assess risk and to incorporate money management into the trading method.
 
The lack of statistical thinking also leads to the belief that you can control the results dictated by chance. Every trading model has a number of features measured by statistics: performance ratios, reliability, etc.. The performance must be assessed in statistics terms in order to avoid the temptation to think we can get much more out of a system.
 

Unreal Estimations Of Returns

Another consequence of this aversion to calculations is the underestimation of the effect of compound interest. This feature also indicates an underestimation of the time factor in capital appreciation. Your trading capital today should be seen as a much larger potential account in the future. But such projections need to be based on a statistical assessment of the trading method, otherwise they will be unrealistic.
The aspiring trader usually wants to make a lot of money in a short time. The result is often a loss of 100%.
 

Lack Of Methodology

Writing down one's ideas has always been a powerful tool for success. Here you have some hints on how to do it properly, by the hand of Jeffrey Kennedy:
 
How is it possible to overcome this fatal flaw? Write down your methodology. Define in writing what your analytical tools are and, more importantly, how you use them. It does not matter whether you use the wave principle, point and figure charts, stochastic, RSI or a combination of these. What matters is that you actually make the effort to define it (i.e., what constitutes a buy, a sell, your trailing stop and instructions on exiting a position). The best hint I can give you regarding developing a defined trading methodology is this – If it cannot be fit it on the back of a business card, it is probably too complicated.

Hitting The Home Run

Overestimating rare occurrences can also lead to the false impression that one can get great benefits with a certain strategy or system, when what really happened was a single occurrence. For these reason, the statistical spreadsheet given to you along with the Practice Chapter C, includes the figure “Net Return without the Maximum Profit Trade”. Such figures are not very common but very useful to project future results.
 

Jump The Gun

There are many reasons which can lead a trader to execute a trade hastily. One of the roots of the problem comes from overestimating the probability of scenarios in which many signals must be met to produce a result. If you have a method that requires the alignment of many signals (or confirmation of several conditions), it will have a lower frequency than a method with less signals. Consider this statistic, otherwise you will find yourself pulling the trigger too often just because you can't get any valid signal from your system.
 

Ignoring Trading Costs

If you don't consider the time frame you are using to trade, it can change the odds of a system. For example, if a system has a high frequency of transactions, new traders typically underestimate the costs derived from the spreads or commissions. It is advisable to take into account this fact. It is amazing the amount of profits generated by a system taken by the broker in the form of spreads or commissions.
In long-term positions, in turn, it may also happen that the trader fails to consider the costs in terms of interest charges in those positions where the difference comes out in favor of the broker (see Chapter A03 for Rollover).
 

Over-trading

Because of the inherently exciting potentials of trading, it is easy to feel like you are missing the party if you do not trade a lot. As a result, you start taking trade setups of lower quality and begin to over-trade. Novice traders feel a need to have a trade on and often are jumping in and out of the market randomly. Over-trading will kill not only your account but also your mindset. Protect your mindset for the quality set-ups instead.
In Forex, the market doesn't close at the end of the day. Other markets give a clean slate to start the next day, but not the Forex. Your have to shut down at some point. Our advice is that you realize that there is always another trade set-up around the corner- specially if your are trading intra-day.