The Most Helpful Question to Ask Yourself

05/21/2014 9:00 am EST

Focus: FOREX

Tyler Yell of DailyFX.com offers tips on how you can overcome harmful trading habits that could torpedo your account and it starts with just asking yourself a simple pre-trade question.


“As a trader, you have to decide what is more important—being right or making money—because the two are not always compatible or consistent with one another.” —Mark Douglas

“We ought not to yearn for things that are not under our control.” Epictetus in Discourses, 3.24

Trading with a closed mind is dangerous business. If you’re new to FX trading, that may sound surprising to you. After all, you likely reason, the best traders are probably the best analysts or those with precise forecasting abilities. This is false and the sooner you learn this, the better and brighter will be your trading future in FX.

Harmful Trading Habits
This article is meant to help you trade with a clear mind so that you don’t fall into some of the most harmful trading habits. As trading is mainly a mental act, the worst habits are often mental and here’s a review:

  • Hindsight Bias or the sense that you knew it all along when looking back on old price action
  • Overconfidence or the feeling that you can’t possibly place a bad trade (due to prior trading)
  • Confirmatory Bias or only seeking out information that confirms your open trades
  • Recency Bias or the anchoring of mind to recent fundamental stories of real price action
  • Self-Attribution Bias or the feeling that good trades are skill and losses are bad luck

This is just a snapshot of some harmful biases. However, the common denominator to these is that you’re only looking on the bright side of the trade and not the potential negative effects in a rather variable or apparently random environment. The mindset that is only fixated on the upside and ignores the downside mentally is often doomed before the trade is even put on.

A Helpful Pre-Trade Question
This may feel esoteric to you but the main purpose is to open up your mind so that you can trade with greater flexibility (read: no longer stubbornly holding a loser). Before you enter a trade, in all reality, you have no idea whether or not you will end up hitting your protective stop or profit target or limit. Because you have no idea, it’s best not to trade as if you know for sure that this trade will be profitable. To prevent this, I’d like to recommend for you to use:

“What’s the worst that could happen on this trade?”
From a trader’s point of view, the worst thing that can and often does happen if you don’t open yourself up to the question’s answer for the next trade is that you’ll over-leverage on a trade that “has to work.” If it doesn’t work, you freeze because you’re afraid to close at such a loss and hope to ride it out till it comes back in your favor. That’s more common than you’d like to imagine so we need to adjust our behavior after that question has been asked.

Adjusting Your Trade Based on Your Answer
This simple answer, or answers to that question could be one of the following:

  • Anything can happen, my stop could get hit
  • This trade could move sideways and become not worth my time and money
  • This trade starts to move in my favor and then reverses sharply on a negative news print

Of course, there are many more options but the idea here is to view where your “perfect trade” could go askew before you put on the trade. New traders often are too ambitious on their trade and are unwilling to accept failure on the next trade, which is humorous considering they have no potential to move the market on their own. By answering this question, you will increase the probability of creating an “exit plan” on the trade, which gives you a hard edge over traders who refuse to consider that their trade may not work out as they wish.

Sample Trade: GBP/USD Technical Showing Bullish Exhaustion/Tempting Short

chart
Presented by FXCM’s Marketscope Charts
Click to Enlarge

Closing Thoughts
The chart above shows a GBP/USD trendline under pressure. Given the recent uprising in the US dollar, many traders are looking to take advantage of the budding USD strength and GBP/USD is one place that traders are looking. However, the highest conviction set-ups can and will be stopped out. Therefore, regardless of the multiple targets, we need to know the worst that can happen on any trade so that we don’t over-leverage or freeze if the market starts moving against us because we’ve already rehearsed this scenario before.

By Tyler Yell, Trading Instructor, DailyFX.com

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