Developing Trading Discipline

No matter which trading style you decide to pursue, you need an organized trading plan, or you won’t get very far. The difference between making money and losing money in the forex market can be as simple as trading with a plan or trading without one. A trading plan is an organized approach to executing a trade strategy that you‘ve developed based on your market analysis and outlook.

Here are the key components of any trading plan:

ü  Determining position size: How large a position will you take for each trade strategy? Position size is half the equation for determining how much money is at stake in each trade.

ü  Deciding where to enter the position: Exactly where will you try to open the desired position? What happens if your entry level is not reached?

ü  Setting stop-loss and take-profit levels: Exactly where will you exit the position, both if it's a winning position (take profit) and if it's a losing position (stop loss)? Stop-loss and take-profit levels are the second half of the equation that determines how much money is at stake in each trade.

That’s it - just three simple components. But it’s amazing how many traders, experienced and beginner alike, open positions without ever having fully thought through exactly what their game plan is. Of course, you need to consider numerous finer points when constructing a trading plan, but for now, I just want to drive home the point that trading without an organized plan is like flying an airplane blindfolded - you may be able to get off the ground, but how will you land?

And no matter how good your trading plan is, it won‘t work if you don’t follow it. Sometimes emotions bubble up and distract traders from their trade plans. Other times, an unexpected piece of news or price movement causes traders to abandon their trade strategy in midstream, or midtrade, as the case may be. Either way, when this happens, it‘s the same as never having had a trade plan in the first place.

Developing a trade plan and sticking to it are the two main ingredients of trading discipline. If we were to name the one defining characteristic of successful traders, it wouldn’t be technical analysis skill, gut instinct, or aggressiveness - though they’re all important. Nope, it would be trading discipline. Traders who follow a disciplined approach are the ones who survive year after year and market cycle after market cycle. They can even be wrong more often than right and still make money because they follow a disciplined approach. Yet establishing and maintaining trading discipline is an elusive goal for many traders.

Taking the emotion out of trading

If the key to successful trading is a disciplined approach - developing a trading plan and sticking to it - why is it so hard for many traders to practice trading discipline? The answer is complex, but it usually boils down to a simple case of human emotions getting the better of them.

I remember an episode of the TV sitcom M *A *S *H, in which Hawkeye Pierce (Alan Alda) observes that the three basic human emotions are greed, fear, and greed. Certainly, that’s the case in financial market trading. When it comes to trading in any market, don’t underestimate the power of emotions to distract and disrupt.

So exactly how do you take the emotion out of trading? The simple answer is: You can’t. As long as your heart is pumping and your synapses are firing, emotions are going to be flowing. And truth be told, the emotional highs of trading are one of the reasons people are drawn to it in the first place. There’s no rush quite like putting on a successful trade and taking some money out of the market. So just accept that you’re going to be experiencing some pretty intense emotions when you’re trading.

The longer answer is that because you can’t block out the emotions, the best you can hope to achieve is understanding where the emotions are coming from, recognizing them when they hit, and limiting their impact on your trading. It's a lot easier said than done, but keep in mind some of the following, and you may find you’re better able to keep your emotions in check:

ü  Focus on the pips and not the dollars and cents. Don’t be distracted by the exact amount of money won or lost in a trade. Instead, focus on where prices are and how they’re behaving. The market has no idea what your trade size is and how much you’re making or losing, but it does know where the current price is.

ü  It’s not about being right or wrong; it’s about making money. At the end of the day, the market doesn’t care if you were right or wrong, and neither should you. The only true way of measuring trading success is in dollars and cents.

ü  You’re going to lose in a fair number of trades. No trader is right 100% of the time. Taking losses is as much a part of the routine as taking profits. You can still be successful over time with a solid risk-management plan.

ü  The market is not out to get you. The market is going to do what it does whether you’re involved in it or not, so don’t take your trading results personally. Interpret them professionally, just as you would the results of any other business venture.

Managing your expectations

Currency trading is a relatively new opportunity for individual traders, and a lot of people have no frame of reference about what to expect when it comes to price movements. A frequent question asked by newcomers is “How much can I expect to make on this trade?” Whoa, Nelly. Talk about a loaded question.

Financial markets are not bank ATMs, and the forex market is certainly no exception. There are a lot of people speculating on which way various currency pairs are going to move; some of those people are going to be right, and some are going to be wrong. Some may also be right for a moment but suddenly end up on the wrong side of equation. Trading can play out in many different ways, but at the end of the day it all comes down to making money or losing money.

Before you get involved with trading currencies, you need to have a healthy sense of what to expect when it comes to trading outcomes. Many people choose to focus on only the upside prospects of currency trading, like the view expressed in that loaded question earlier. But losses are part of trading, too. Even the biggest and best traders have losing trades on a regular basis.

One of the keys to establishing trading discipline is to first accept that losses are inevitable. The second step is to dedicate yourself to keeping those losses as small as possible. Most experienced traders will tell you the hardest part of trading is keeping the money you've made and not giving it back to the market.

Imagining realistic profit-and-loss scenarios

The trading style that you decide to pursue will dictate the relative size of profits and losses that you can expect to experience. If you’re trading on a short- to medium-term basis, look at average daily trading ranges to get a good idea of what to expect.

The average daily trading range is a mathematical average of each day's trading range (high to low) over a specified period. Keep in mind that this figure is just a statistical average - there will be days with larger ranges and days with narrower ranges. Also, average daily ranges will vary significantly by currency pair.

But the average daily trading range covers a full 24-hour trading session and tends to overstate what short- and medium-term traders can expect from intraday trading ranges. Generally speaking, you’re better off anticipating more modest price movements of 30 to 80 pips rather than aiming for the homerun ball.

And no matter what any infomercial tells you, you’re not going to retire based on any single trade. The key is to hit singles and stay in the game.

Balancing risk versus reward

Trading is all about taking on risk to generate profits. So one question is frequently posed: “How much should I risk in any given trade?” There is no easy answer to that question. Some trading books advise people to use a risk/reward ratio, like 2:1, meaning that if you risk $100 on a trade, you should aim to make $200 to justify the risk. Others counsel to never risk more than a fixed percentage of your trading account on any single trade. It's all a bit formulaic, if you ask me, and it also has no relation to the reality of the markets.

A better way to think about risk and reward is to look at each trade opportunity on its own and assess the outcomes based on technical analysis. This approach has the virtue of being as dynamic as the market, allowing you to exploit trade opportunities according to prevailing market conditions.

Another factor to consider in balancing risk and reward is the use of leverage. In online currency trading, generous leverage ratios of 100:1.1 or 200:1 are typically available. The higher the leverage ratio, the larger position you can trade based on your margin. But leverage is a double-edged sword because it also amplifies profits and losses.

The key here is to limit your overall leverage utilization so you’re not putting all your eggs in one basket. If you open the largest position available based on your margin, you’l1 have very little cushion left in case of adverse price movements. It may seem sexy to trade as large a position as possible, but whoever said prudent, risk-aware trading was supposed to be sexy? Keep your feet on the ground, and don’t lose your head in the clouds of leverage.

Keeping your ammunition dry

The margin you’re required to post with your forex broker is the basis for all your trading. The amount of margin you put up will determine how large a position you can hold and for how long (in pips) if the market moves against you. Unless you just won the lottery, your margin collateral is a precious, finite resource, so you have to use it sparingly.

If Hamlet were alive today and trading currencies, his famous soliloquy might begin “To trade or not to trade?” One of the biggest mistakes traders make is known as overtrading. Overtrading typically refers to trading too often in the market or trading too many positions at once. Both forms suggest a lack of discipline, and sound more like throwing darts at a board and hoping something sticks.

Keeping your ammunition dry refers to staying out of the market, watching and waiting, and picking your trades more selectively.

Opportunity lost or opportunity cost?

One of the more popular market aphorisms is “You've got to be in it to win it." Though it’s obviously a truism, we would counter that trading discretion is the better part of trading valor. Holding open positions not only exposes you to market risk, but can also cost you market opportunities.

After you enter a position, your available margin is reduced, which in turn lowers the amount of available positions you can establish. If you’re routinely involved in the market because you don’t want to miss out on the next big move, you actually run the risk of missing out on the next big move because you may not have enough available margin to support a position for the big move.

Don’t be afraid about missing out on some trade opportunities. No one ever catches all the moves. Instead, focus on your market analysis and pinpoint the next well-defined trading opportunity.

Thinking clearly while you can

Another virtue of trading less frequently is that your market outlook is not skewed by any of the emotional entanglements that come with open positions. If you ask a trader who’s long EUR/USD What he thinks of EUR/USD, surprise, surprise - he’s going to tell you he thinks it’s going up. That’s called talking your book.

But being out of the market, or being square, allows you to step back and analyze market developments with a fresh perspective. That’s when you can spot opportunities more clearly and develop an effective trade strategy to exploit them. All too soon, you‘ll be on to your next trade, and the emotional roller coaster will start all over again.