What is the Psychology Behind Forex Trading?

Forex trading is a complex activity that not only requires a strong understanding of market fundamentals and technical analysis, but also a deep understanding of human psychology. Successful forex traders recognise that their mindset plays a crucial role in their trading performance.

Trading psychology is made up of several mental and emotional factors that impact all types of traders, regardless of expertise. Learning and personal development are invaluable tools for boosting trading psychology. This article will discuss the relationship between forex trading and psychology and how biases such as overconfidence and herd behaviour influence trading decisions.

Psychology in forex trading

Emotions are a natural part of human psychology, and they can significantly impact trading behaviour. The most common emotions experienced by forex traders include:

Greed

Greed can be described in psychology as an excessive desire for wealth, so intense that it often affects a trader’s ability to make rational decisions.

Greed can drive traders toward a variety of suboptimal behaviours, such as making high-risk trades, buying shares of an untested company or technology because their prices are rapidly increasing, or buying shares without proper research.

Additionally, greed may compel investors to remain in profitable trades for too long to maximise profits or take on large risky positions. This behaviour is most noticeable during the final phase of bull markets when speculation is high and caution is ignored.

Fear

Conversely, fear drives traders to close positions too early or avoid taking risks due to concerns about major losses. This emotion is especially strong during bear markets, often leading to irrational decisions as traders rush to exit the market. Fear can quickly turn into panic, generally causing widespread selloffs in the market from panic selling.

Regret

In psychology, regret can lead a trader to enter a trade after initially missing it because the stock moved too fast. This break in trading discipline often leads to losses as prices drop from their peak highs.

Behavioural biases

Traders generally face two types of behavioural biases: cognitive biases and emotional biases. Cognitive biases are errors or blind spots in thinking, common to human beings, which result from subconscious mental processes. Examples include overconfidence bias, anchoring bias, among other examples.

Emotional biases arise from feelings, moods, perceptions, or beliefs and include herding behaviour, loss aversion bias and the emotional impacts of fear and greed, etc.

Both cognitive and emotional biases can result in irrational judgments and poor decision-making.

Let’s look at a few of these below:

Overconfidence

In psychology, overconfidence is when you overestimate your own abilities, skills, and knowledge. Many traders think they are more skilled in trading than others. So overconfident traders often trade excessively, leading to higher transaction costs and poor performance.

Studies also show that these traders overestimate their predictive abilities and the accuracy of available data, resulting in emotionally driven behaviour and excessive risk-taking. This can result in significant losses when the market moves against them.

Herd Behavior in Psychology

In psychology, herd behavior describes how people tend to copy the financial actions of the majority. The natural human desire to belong to a group can influence investors to mimic the actions of others. When a large group moves in one direction, an individual may feel uncomfortable going in the opposite direction.

Consequently, investors often join buying trends without doing their own research, assuming others have already done so. For example, during the dotcom bubble, lots of investors rushed to buy internet company stocks, hoping for big profits. But when these profits didn’t materialise, prices crashed sharply.

Emotional gap

The emotional gap happens when people make decisions driven by strong emotions like anxiety, anger, fear, or excitement. Emotions can lead to irrational choices. Fear and greed especially can cause people to overreact. This can create situations like unfounded optimism, excessive enthusiasm and asset bubbles, or conversely, market panic and big sell-offs.

Anchoring

Anchoring means attaching a financial decision to a random reference point. Examples may include spending consistently based on a budget level or rationalising spending based on personal satisfaction levels. Investors may use irrelevant information, like their purchase price of a security as a reference point, or anchor, for their decision making.

This could lead them to hold onto investments that have lost value because they have anchored their estimate of fair value to their original purchase price. Such traders may hold the security, hoping it will return to the purchase price, without considering its future prospects or outlook.

Self-attribution

Self-attribution is when individuals credit their successes to their own personal abilities, while attributing failures to external factors. This often arises from an intrinsic knack in a specific area. Within this category, individuals tend to rate their knowledge higher than others, even when their actual expertise may fall short. For instance, a trader may believe their good performance is due to their great decision-making skills. On the other hand, they might blame their poor performance on bad luck rather than poor decision making.

Loss Aversion

Loss aversion is a common psychological error where traders worry more about losses than they enjoy gains. Losses trigger stronger emotional responses than equivalent gains. This can lead traders to hold onto losing trades for too long, hoping to avoid realising a loss.

Common pitfalls of neglecting trading psychology

Investors and traders can face several pitfalls due to behavioural biases, including:

1. Selling winning investments too soon:Quickly selling profitable trades while holding on to losing ones, hoping they will bounce back to the purchase price.
2. Herd behaviour: Following the crowd by chasing after recent top-performing assets without proper research or considering future potential.
3. Impulsive decisions: Acting on information impulsively, driven by a misplaced confidence in their own trading skills.
4. Overtrading: Trading excessively, while underestimating risks and failing to diversify their portfolio.
5. Emotional reactions: Making decisions based on fear or greed, especially during periods of market volatility.

Understanding trading psychology can help you avoid these pitfalls and make more informed, rational decisions.

How can traders overcome psychology biases to avoid pitfalls?

Traders can use various strategies to overcome biases and avoid common pitfalls:

Enhance self-awareness psychology

Learning about behavioural finance principles can help traders become more aware of their own biases and improve decision-making.

Develop a trading plan

Creating and following a trading plan with trading rules and risk management practices can provide a structured approach to trading, reducing emotional decision making.

Conduct objective research

Performing objective fundamental or technical analysis research and seeking a range of data to support the analysis, including opposing views, can help traders avoid following the crowd and challenge their own assumptions.

By using these strategies, traders can make more informed and rational decisions, minimising the impact of behavioural biases.

Discipline and confidence

Discipline is crucial for maintaining a positive trading psychology. Lack of discipline oftens results in impulsive trading, chasing losses or ignoring established trading rules, all of which can harm trading performance. Maintaining discipline requires sticking to a trading plan, following the rules of trading strategies, and adhering to risk management criteria. This needs self-control, patience, and resilience to cope with disappointment.

Confidence is also essential for disciplined trading. Traders need to trust their abilities and their trading plan. However, a balanced approach is key. Too little confidence can cause hesitation and missed opportunities, while overconfidence can lead to excessive risk-taking and failure to adapt to market changes. Finding the right balance of confidence helps ensure consistency and success.

Developing effective risk management psychology

Risk management is an important part of trading psychology. By focusing on learning and personal development, traders can improve their risk management skills to avoid potential losses. This involves setting appropriate stop-loss levels, diversifying their portfolio, and avoiding impulsive or emotional trading decisions. Understanding the importance of risk management and applying effective strategies helps traders protect their capital and achieve consistent profitability over the long term.

In summary

Trading psychology plays a vital role alongside knowledge and skill in determining trading success. Biases or subjective prejudices, heuristics or unconscious mental patterns, and emotions such as fear and greed impact traders’ decision-making processes and their overall trading performance.

Behavioural finance aims to understand these influences on financial decision making and how this affects financial markets. Some common behavioural biases include overconfidence, herd behaviour, the emotional gap, anchoring, self-attribution and loss aversion. Understanding these behavioural concepts can lead to better decision making and improved trading outcomes.

Disclaimer:
This information is not considered investment advice or an investment recommendation, but instead a marketing communication. IronFX is not responsible for any data or information provided by third parties referenced or hyperlinked in this communication.