PSYCHOLOGY IN FOREX TRADING

FOREX TRADING PSYCHOLOGY

Recently, a friend requested I give a talk on forex trading psychology, needless to say it wasn’t necessarily a request. The matter was already decided, I had to assume the responsibility of preparing for the talk.

I have spent the better part of January 2024 trying to figure out and generate content on this subject matter. I have come to a conclusion; market psychology is the mother of trading psychology. We tend to view individual trading psychology independent of the market, our trading results can confirm this.

Allow me to develop the conceptual framework that leads to my conclusion. For the better part of this article, I will advocate for market psychology as opposed to trading psychology, a matter of perspective.

Psychology by definition is the study of behavior, ideally with the intention of increased understanding. I will also share that environments do dictate behavior. Therefore, market psychology(environment) is superior to trading psychology. In other words, the behavior of the market determines the behavior of traders.

With this framework, would it be ideal to study market psychology? Ultimately, we will understand ourselves better. In my experience, I have learnt that the market is both mean and generous in equal measure. It depends what side you receive. Is it possible to consistently receive her generosity? Yes, it is. How do we do this?

Firstly, we need to understand and accept that;

1. The market doesn’t care about you or your goals.
2. The market doesn’t care about your desire and timelines.
3. The market doesn’t care that you use indicators or whatever trading style
4. The market doesn’t care that you use technical or fundamental analysis
5. The market doesn’t care about your emotions, it is not in a relationship with you.

The market doesn’t care.

The market only cares about one thing; efficient price delivery.

Reason would dictate that we need to approach the market without ANY expectations. Submit to the market, seek to learn its price delivery behavior (psychology) and then it shall reveal itself to you. Gradually, the market modifies your behavior and mindset. Therefore, consistent exposure and pursuit of market psychology builds and modifies individual trader psychology.

Time and dedication are the answers to figuring out market and trader psychology. Time, is a trader’s greatest weapon or undoing. For example, we know, every break of structure is followed by a correction. The purpose of a correction is to remove previous disequilibrium (imbalance and inefficiency) before continuing with the main trend.

What we don’t know is how long a correction will take or when the trend will change. Often times, the state of not knowing has caused may traders to act irrationally consequently blowing accounts.

If we know this, then why do we fail? We project our feelings and expectations on the market. Recall, the market doesn’t care.

Repeatedly court the market, sit and ask what is going on, why is it happening and how is it happening, the market will answer and increase your understanding and depth of psychology.

When you do the following, market psychology has modified your behavior (psychology);

1. You no longer chase after trades. Instead, you let trades come to you no matter how long it takes.
2. You learn to differentiate between lost and missed opportunities.
3. When you learn that high risk doesn’t necessarily equate to high return.
4. Your objective is risk minimization and not profit maximization.
5. When you accept that two people can see the same charts differently.
6. Its about the quality and not the quantity of trades.
7. When you learn that less is more, and slow is fast
8. Excessive leverage is not your friend.
9. Spreads and market manipulation don’t make you better or worse.

In conclusion, it doesn’t matter what technique you use; market psychology is inevitable if you must succeed in your journey in forex trading. It is the case of what comes first, the chicken or the egg.

 

WHEN DESIRE TRUMPS REASON

When desire trumps reason, disaster ensues.

Desire ; a strong feeling of wanting to have something.

Reason ; the power or ability of the mind to think, understand, and form judgments logically.

 A disaster is an event that results in great harm, damage, or death.

Therefore, in summary, if Desire >Reason = Disaster.

From the definition above, human beings should, by all means, endeavour to place reason above desire. However, our daily existence is a representation of the opposite. Our lives are filled with instances where we consciously let desires rule over us with consequences registered later on.

In the world of retail forex trading, desire seems to rule supreme over reason. Like any other business, forex trading ascribes to the ebbs and flows of business cycles and phases. Consequently, it takes time to build mastery, a credible track record, and profitability.

From the study of economics, we learn that an overwhelming desire for a product or service, otherwise known as demand leads to the creation of a market for that commodity. The overwhelming desire for supernormal profits in forex within the shortest time possible has led to the creation and rise of questionable ‘solutions’ in the form of;

1. Proprietary software (indicators & robots)
2. Account management and
3. Unregulated investment services.

Emphasis is placed on approaching forex trading as a business. Profitability is a result of consistency in learning, practicing, and implementing sound, reasonable trading practices. Note that your primary objective is learning then application of the concepts acquired.

This journey takes time. Unfortunately, a majority of new entrants in the forex space do not desire to surrender themselves to the process of learning. Enter desire, exit reason. A quick survey on social media platforms leads you to gurus selling proprietary software or account management services. These services promise exponential returns in the shortest time possible. Desire goes into overdrive, imagination deludes you into believing that you will earn millions by a certain time. To some degree, hubris sets in. This ‘solution’ deludes us into thinking we are smarter than the rest.

As mentioned earlier, businesses go through cycles and phases. Profits are a lagging indicator of what the business has implemented in the recent past. Reason therefore dictates that overnight or exponential short-term profits are an illusion. From this premise, the ‘solution’ is unsustainable and probably a scam. At this point, however, desire is strangling reason and we end up committing our resources. The outcome is usually disastrous, financially.

Why do these ‘solutions’ fail?

It goes back to an unhealthy and overwhelming desire for quick profits. Unhealthy and overwhelming desire to shorten the learning curve.

In the case of account management and questionable investment services, we desire to cede control to a third party. Whoever is trading/managing your account has no attachment to the capital invested. They have no incentive to trade conservatively, eventually, they become reckless, especially in account management. This happens when we insist on eliminating the process of learning by ceding control to a third party.

For instance, the account management below is found on Instagram promises 100% weekly profit. Upon close interrogation, you will notice the comments section is disabled. Why is it disabled? ideally you want to prevent honest realistic feedback from the public.

Questionable investment services are a special kind of scam. Usually, you will see an ad on social media promising to exponentially grow your capital within a certain time. In addition to the ad, there is ‘evidence’ of individuals receiving large payouts. Automatically, your desire kicks in. Such services thrive in obscuring their true intentions under the guise of forex, crypto or other types of investment. I have seen many individuals ‘invest’ in such scams. There is no proof of actual investment or trading that takes place. The messages displayed on their social media pages have been fabricated and edited to elicit desire. Once your capital is committed, there is no recovery, thereafter it’s a series of ignored communication, reasons and excuses.

Lets check this example below,

 

The page conveys the information that within 7 hours, you will earn exponential profits. Let us go further and see what else is visible from this account.

 

Interestingly, the page also displays fake information. The letterhead from the Central Bank of Kenya lends credibility to this page. However, further investigations reveal that the Capital Markets Authority maintains a list of all licensed brokers in Kenya. Multivest LLC number 112 is not part of the list. Therefore, this would constitute fraudulent behaviour.

Below is the actual list from the Capital Markets Authority

 

Finally, we look at the logo which is a replica of a well-known prop firm; City traders Imperium. There idea is to use such logos to lend credibility to the scam.

There is a possibility a lot of individuals have fallen victim to this scam driven by the universal overwhelming desire to become wealthy in the shortest time possible.

Proprietary software (robots & indicators)

People tend to procure this ‘solution’ because it allows us to transfer our analytical and reasoning abilities to software that tells us when to act. Human beings tend to prefer the path of least resistance. We do not necessarily desire to submit to the process of learning, instead we desire shortcuts. Unfortunately, we do not know what information the software uses to make decisions or even how it works. We are not interested in asking such questions, if we asked such questions, we would be forced to learn how to trade which consumes time, and time that we do not intend to dedicate to the process of learning.

For instance, the Instagram page below advertises an indicator claiming you will earn 500$ daily. Note, the comments on this Instagram page are disabled.

For the sake of clarity, there are forex robots that do work. However, they are not affordable and accessible to low & middle-income traders. Such bots cost at least 5000$. Further, these bots require a well-capitalized account of at least the same amount as the purchase price.

Nothing comes to you by osmosis or desire. You must work for it. What you invest in, you become good at. Ceding control to our desires and thereafter to third parties leads to unhealthy exposure to risks and outcomes. Often it ends in disaster.

I am no exception to this weakness. Severally, I have let desires overrule my reasoning, the outcome of course is predictable. In response to the disastrous outcome, I forced myself to learn the art of forex trading.

If we all submitted to the process of learning, practicing, and improving our forex trading craft, we would be in control of the risk exposure and the accompanying outcomes thereby guaranteeing a higher chance of success.

LIQUIDITY IN FOREX TRADING

 

Understand that for a trade to occur, there must be two counterparties; a buyer and a seller i.e. for every buyer, there must be a seller and the reverse is true. Liquidity is the ease with which one can convert an asset to cash without losing significant value.

For instance, if you have an asset priced at 4$ and you can sell it/convert it to cash it is because there is liquidity, the willingness of another party to accept the asset at 4$. However, if we have to offer the asset for sale at a lower price to convert it to cash, let’s say at 3$ then there is no liquidity in the market. This lack of liquidity happens when we do not have enough buyers or sellers for a particular asset, hence the significant discounts to attract them. This concept is not only applicable in forex, it is one of the key concepts that drives the forex market.

Every buy transaction must have a willing seller and vice versa. If this situation cannot hold, suppose we do not have a willing counterparty the market must create/engineer liquidity. Retail forex traders refer to this concept as market manipulation while institutional traders refer to this concept as engineering and sweeping liquidity. Engineered liquidity facilitates large institutions to come into the market efficiently. Liquidity ensures volumes of currencies are traded efficiently.

NB; If you cannot identify liquidity, chances are you are the liquidity waiting to be swept.

 

How to identify liquidity?

To understand liquidity concepts, we must first understand how retail traders look at the markets. Retail traders use popular techniques to analyze the markets such as trend lines and patterns. Institutional traders on the other hand tend to use more technical concepts such as smart money concepts (SMC) or institutional order flow.

Some of the popular concepts used by retail traders include;

• Double bottom, triple bottom, or equal lows.

Formed when markets create two or three equal lows. Usually, retail traders use this pattern to buy with a stop loss just below.

• Double top, triple top, or equal highs.

Formed when markets create two or three equal highs. Usually used by retail traders to sell with a stop loss above it.

• Trendline

Trendlines are formed when markets move within an upward or downward channel.

In an upward channel, retail traders buy when the market touches the lower trend line and sell when the market touches the upper trend line.

In a descending/downward channel, retail traders sell when the market touches the top trendline and buy when the market touches the bottom trendline.

How is liquidity engineered?

Recall that for a trade to occur, we require two counterparties, a buyer and a seller.

Let’s start with a double bottom.

The first image on the right represents the present market conditions where retail traders have already bought at points A1 and A2 with their stop losses sitting just below A1 A2. Presently, the market is at point A. Institutional traders want to enter the market and buy, however, there are no willing counterparties i.e. sellers. At point A, institutional buyers have the ability but are also not willing.

So how will the institutional buyers get into this market? By engineering liquidity that will attract sellers into the market. Once enough sellers are availed, they will buy at a lower point as originally intended.

 

How will they do this?

Since there are few sellers, they will become the sellers and push the market lower from point A towards A1 A2. Remember that institutional traders do have the financial muscle to push markets in either direction. As the market pushes lower, retail traders see this as a signal to add more buys. Why? The illusion is that this is now a triple bottom and, therefore, a buy. At this point, the sellers(institutional) are matching the buyers. What retail traders on the buy side don’t know is that the institutional traders seek to drive markets even lower, sweeping the set stop loss and recording it as their profits.

Once the sweeping is done by pushing prices lower, the retail sellers are alerted. Sellers jump in thinking the market is now bearish. Once enough sellers are in, the institutional traders now become buyers as they had originally intended and push the market higher thereby trapping sellers.

The image above depicts this liquidity phenomenon perfectly where liquidity was engineered to trigger and trap sellers.

Double top

We will build on the earlier concept and look at double tops. Presently, the market is at point A. Retail traders having spotted the double top have sold (short selling). At the current market price, institutional traders are able but not willing to sell at this price. Recall that supply is the price at which sellers are able and willing to sell, usually at a high price. Also recall that for sellers to enter the market, we need a counterparty, buyers in this case. Presently, there is no liquidity because we have no buyers. So how will institutional traders get into this sell market? They will engineer liquidity and push prices higher and sweep stop losses (A1 A2).

How will they do this?

Firstly, they will volunteer to buy and push prices higher towards A1 A2 targeting stop losses at this region which shall be recorded as profits. As the prices approach A1 A2, more sellers are attracted thinking it’s a triple top/equal high.

Institutional traders push the prices well beyond A1 A2 and trigger buyers into thinking it’s a bullish break of structure. When enough buyers are in the market (providing the much-needed liquidity), institutional traders will now sell as originally intended as depicted in the image above.

How about trendlines

Apart from double tops (equal highs) and double bottoms (equal lows), retail traders also use trendlines; upward and downward.

Retail traders use the trendline concept to place buy or sell orders. From a theoretical perspective, once the price hits a trendline (top or bottom) retail traders place trades.

Once price hits A1, A2, and A3, retail traders buy. Once prices hit B1 and B2, retail traders sell; a fairly simple concept. In this upward channel, suppose prices are at point A, institutional buyers want to buy but not at that price; A. At that price we have an imbalance, more buyers want to come in but no sellers to offer a counter position. Just like before, liquidity will be engineered.

Institutional traders will offer to sell and drive prices towards A1, A2 and A3. From a retail perspective, every time the price touches the lower trend line retail traders buy with stop losses below. Institutional traders know this and that’s what they are targeting. They will drive prices lower, and more buyers thinking the trend line will hold will buy. Institutional traders want to create liquidity for themselves to enter and place buy orders, therefore, they will drive prices lower, beyond A3, and wipe out previous buy orders (sweep the stop losses). Once this act is complete. Sellers will think it is a breakout and mount numerous sell orders. Once we have sufficient sell orders, institutional traders enter and place buys as originally intended. 

NB: The concept above is also applicable for a sell in an upward channel and both sell and buy in a downward channel.

 

How to use liquidity to your advantage?

Liquidity drives markets and facilitates efficient trading in any type of business and market. In forex, I use a combination of fresh order blocks and liquidity to inform my trade entry (limit orders) and exits (take profits). Join my course to learn more about liquidity and forex trading.

 

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