Trading psychology impacts market psychology and has more to do with behaviors that you can change than it does with therapy. If you are going to be doing this for a long time, you have to enjoy it. I love my job and have for more than 30 years, and I still look forward to trading every day. Although you might be able to make more money by pushing yourself to your emotional and physical limits, you will probably hate what you are doing and be unable and unwilling to do it for decades.
Traders must be happy
Life is short and I don’t want to waste it on misplaced priorities. Your happiness and that of your family are far more valuable than that extra dollar. An important part of learning how to trade is finding a style of trading that is right for you. Don’t worry if you see a successful trader on television who is doing something entirely different and making a fortune.
Traders often take years to discover and accept their comfort zones as they learn how to trade. Some prefer to take trades with a high probability of success, which is fine, but they understand that there is a trade-off. High probability trades usually have a relatively low profit potential compared to risk.
Other traders want a reward much bigger than the risk, and they don’t care that this means that they will be taking trades that will lose most of the time. They know that if they manage their trades well and go for a reward that is two or more times greater than their risk, they will make money even if they lose money on 60% of their trades.
Trading psychology and the “I don’t care” position size
As traders, we swim in a sea of uncertainty, and until you can free yourself from emotion, it is impossible to follow what the institutional computers are doing, and you can only make money if you do. When you decide to take a trade, be honest about just how far away your stop has to be, which often creates a greater risk than you want.
You have to trade a small enough position size so that you really don’t care very much if you win or lose…the “I don’t care” size. This gives you the best chance at remaining objective when you enter and exit your trade.
A beginner is quick to do the math…“If I” make $100 a day with one contract, I will make $2 million a year with 100 contracts!” He is too quick to think about trading big positions, and even when he starts out, trading what he thinks is a small position, he is usually trading too big.
How can a beginner tell if his position size is too big? That’s easy. He just has to ask himself, “Did I manage all of my trades today as I should have, or did I have several trades where I exited too early because I was feeling nervous over how much I would lose if my stop got hit?” If he did not manage correctly, then he cared. He is trying to compete with computers who have no feelings and certainly do not care about anything.
Trade the “I don’t care” size
My recommendation is that traders should trade their “I don’t care” size. Whatever a trader thinks it is, he should then trade 50 – 75% smaller so he really won’t care if the trade goes against him. Over time, he can handle larger positions while still not caring. If he increases too quickly, he can back off and try to increase again later.
When I tell traders this, some get angry and quickly ask me how they can ever get rich trading so small. The answer is simple. Successful traders don’t constantly think about getting rich, although many end up that way.
Instead, they only think about doing the right thing all day long. That is the first goal. They know that if they do, they will make money, which is the second goal. Sometimes, they will make a lot of money, which is the third goal, but they never worry or think about that.
Remember, most successful traders are not making $100 million dollars a year. However, many make far more than the richest doctors and lawyers, and that is plenty to have a great life.
The Trader’s Equation and the 40-60 Rule
Most traders, especially beginners, should only swing trade, which I define as going for a target that is at least twice as large as the potential loss. Remember the Trader’s Equation and the “40 – 60 rule”. Since the probability of 90% of trades is between 40 and 60%, a trader who goes for a reward that is at least twice as big as his risk is trading a mathematically sound approach.
A good start is to look for Major Trend Reversals. For example, if a trader is trading the Emini and using a 2 point stop and a 4 point profit target, he will probably make 4 or more points on 40% of his trades and lose 2 points on another 40% of his trades. The remaining 20% of trades will usually be small losses and wins that offset each other. The result is a net profit and therefore a positive Trader’s Equation.
Avoid confusing swings and scalps!
A trader often loses money because he takes a trade with one goal and manages it as if he entered with a different goal. For day traders, this usually happens because the trader entered, thinking he was going to hold for a swing, but instead managed the trade like a scalp.
For example, if he shorted the EURUSD Forex market at what he thought was a strong top and was planning on holding for a 100 pip (tick) profit while using a 20 pip protective stop but instead always exited this type of trade whenever he had a 10 pip profit, he will lose money over time. He might consistently convince himself that the price action unfolded differently from what he expected, and this change in his premise justified changing the trade from a swing to a scalp.
However, if he discovers that he is doing this with just about every trade, he will lose money. This is because a swing trade usually has a low probability of success, but the expected reward is many times greater than the risk and that creates a positive Trader’s Equation. If he instead always accepts a profit that is not many times bigger than his risk, he will lose money over time with low probability trades, which most swing trades are.
Don’t turn a good swing into a scalp
If a trader always changes his mind and grabs a scalper’s profit, he is actually scalping, even though he thought that he was swinging. Plug some numbers into the Trader’s Equation. A typical swing setup has about a 40% chance of success. If the trader is risking 10 pips to make 10 pips, he will lose money. To make money on a scalp, a trader needs a high probability of success (60% or more) because his reward is usually about the size of his risk.
At any instant in any market, a trader can trade profitably by buying or shorting for a swing because the probability of success for a profitable long or short is rarely ever less than 40%. This means that if he manages his trade correctly and holds for a reward that is at least twice as large as his risk, he will make money over time. Traders should only scalp if the probability is 60% or higher.
Most traders need to swing trade
Most traders cannot consistently maintain this high a probability and therefore should swing all of their trades (my definition of a swing is any trade where your intended reward is at least twice as big as your risk). It is important to note that some experienced scalpers win more than 90% of the time, but this is rare, and usually involves scaling into and out of positions.
Many experienced traders scale into trades to greatly increase the probability of their position. However, beginners should be very careful about this because they almost always scale into the wrong trades.
A common example is scaling into what they believe is a pullback when they do not realize that it is actually a reversal. They can quickly lose far more money than they imagined was possible, but that makes sense. If you are trying to get more probability, you have to pay for it with some combination of increased risk or reduced reward.
Good is good enough
Find out who you are and be happy that you can do all that you can do. A baseball player does not have to be a home run hitter to get in the Hall of Fame. If he consistently hits lots of singles, he will get there. You do not have to be the best to be rich, but you have to be happy, consistent, and disciplined to achieve your goal.
Thank you for reading my How To Trade Price Action manual.
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