Forex trading, with its promise of financial freedom and independence, has captivated the minds of millions around the globe. Yet, beneath the surface of charts, indicators, and currency pairs lies a complex landscape shaped not just by market dynamics but by the intricate workings of the human mind.
Success is not solely dictated by market knowledge or technical prowess but by the ability to master one's own trading psychology. This article delves deep into the psyche of successful forex traders, exploring the mindset, habits, and strategies that set them apart from the rest.
Whether you're a novice trader taking your first steps into the world of forex or an experienced investor seeking to enhance your trading performance, understanding the psychological aspects of trading is paramount to achieving lasting success. Join us as we unravel the mysteries of the human mind and discover the keys to unlocking your full potential in the forex market.
The concept of "success" in forex trading is a bit of a hot topic. Some see it as being all about the money, while others argue it's more about staying consistent, managing risks, and growing as a trader. Plus, success means different things to different people, so what floats one trader's boat might not do it for another.
At the heart of successful forex trading lies the understanding of one's own trading psychology and the ability to manage emotions effectively.
Successful forex traders share common traits that set them apart from the rest. These include discipline, patience, adaptability, and a willingness to accept losses as part of the trading process. They approach the market with a clear plan, stick to their strategies, and remain unphased by short-term fluctuations.
Emotional intelligence plays a pivotal role in forex trading, enabling traders to recognise and manage their emotions effectively. Successful traders cultivate self-awareness, self-regulation, and empathy, allowing them to make rational decisions even in high-pressure situations. By understanding their emotional triggers, they can maintain composure and avoid impulsive actions.
Self-awareness involves recognising one's emotions and their impact on trading decisions. Successful traders are attuned to their emotional state and take proactive steps to prevent emotions from clouding their judgment. Self-regulation is the ability to control impulses and maintain discipline in the face of temptation. Successful traders develop strategies to manage stress, anxiety, and other negative emotions that can interfere with trading performance.
Empathy is also important in forex trading, as it allows traders to understand the perspectives and motivations of other market participants. By putting themselves in the shoes of other traders, successful traders can anticipate market movements and react accordingly. Empathy also helps traders build relationships with other market participants, fostering collaboration and mutual respect.
Successful traders also have an understanding of cognitive and confirmation biases. We recommend all traders read our two-part series on the 10 hidden biases here:
Remember, that everyone faces the same challenges in the markets. Only those who can overcome the psychological barriers in trading end up succeeding over the long-term. Sometimes in bizarre market conditions, or on an off day, it’s better to take a step back and examine why we’ve been behaving and thinking as we have.
Whether you're a novice trader or an experienced investor, cultivating emotional intelligence, embracing risk management, and maintaining a winning mindset are key to thriving in the competitive forex market. As you embark on your trading journey, remember that success is not just about profits but about the journey of self-discovery and growth.
Embarking on your forex trading journey might seem daunting at first, but fret not! We’ve put together all the information you need to get started.
This guide is your friendly companion, packed with real-world examples, easy-to-grasp basics, newbie-friendly strategies, handy tips, and a step-by-step roadmap to kickstart your forex adventures.
Foreign exchange trading, or forex trading, is the process of buying and selling currencies in the global financial markets. It is one of the largest and most liquid markets in the world, with an average daily trading volume estimated to exceed USD$7 trillion. Unlike traditional stock markets, forex trading operates 24 hours a day, five days a week, allowing traders to participate in the market at any time.
Understanding currency pairs
Forex trading involves the exchange of one currency for another at an agreed-upon price. This is done with the aim of profiting from fluctuations in exchange rates. Currencies are traded in pairs, where one currency is bought while the other is sold. The most commonly traded currency pairs, or ‘the majors’ as they’re more commonly referred to, include EUR/USD (Euro/US Dollar), GBP/USD (British Pound/US Dollar), AUD/USD (Australian Dollar/US Dollar), NZD/USD (New Zealand Dollar/US Dollar), USD/JPY (US Dollar/Japanese Yen), USD/CAD (US Dollar/Canadian Dollar), and USD/CHF (US Dollar/Swiss Franc).
Examples of other currency pairs, most often referred to as “crosses”, are AUD/JPY (Australian Dollar/Japanese Yen), GBP/NZD (British Pound/New Zealand Dollar), EUR/CAD (Euro/Canadian Dollar) and so forth.
And finally, less-traded currency pairs are referred to as “exotics”. Examples of these include USD/TRY (US Dollar/Turkish Lira), USD/HUF (US Dollar/Hungarian Forint). It’s important to note that exotic pairs tend to have wider spreads and higher volatility compared to major and minor pairs.
Uses of the forex market
The forex market is used by many players, for many different reasons. Retail traders aim at buying or selling a currency to take advantage of short-term fluctuations in price, whereas corporates who conduct regular international trade often use the forex market to hedge against their local currency weakening.
Large-scale players such as hedge funds or investment firms, will use the foreign exchange market to take advantage of divergences in interest rates between two nations in the form of a carry trade.
For more information on the types of forex trading, head to Part Four.
Reading Currency Pair Quotes
Currency pair quotes consist of two prices: the bid price and the ask price. The bid price represents the price at which you can sell the base currency, while the ask price represents the price at which you can buy the base currency. The difference between the bid and ask prices is known as the spread, which represents the broker's profit margin.
In forex trading, currency pairs are quoted in pips, short for "price interest point," representing the smallest possible price movement. For most major currency pairs, prices are quoted with four decimal points, indicating a change of 1/100 of one percent or 1 basis point. However, the Japanese Yen is an exception, trading with only two decimal points.
For instance, if the bid price for the EUR/USD pair is quoted as 1.19040, this breakdown refers to the five decimal places displayed on the market watch.
In order to trade the foreign exchange market effectively, you need to understand the nuts and bolts of how it works.
The forex market is decentralised, meaning that there is no central exchange where all transactions take place. Instead, trading occurs over-the-counter (OTC) through a global network of banks, financial institutions, and individual traders. Some of the larger players in the forex market are Deutsche Bank, UBS, Citi Bank, RBS and more.
Prices are determined by supply and demand dynamics, with exchange rates fluctuating based on economic indicators, geopolitical events, and market sentiment.
How the system works
Market makers are key players in the forex world. They establish both the buying (bid) and selling (ask) prices, which are visible to everyone on their platforms. Their role extends to facilitating transactions with a diverse clientele, including banks and individual traders. By consistently quoting prices, they inject liquidity into the market. As counterparties, market makers engage in every trade, ensuring a seamless flow: when you sell, they buy, and vice versa.
Electronic Communications Networks (ECNs) play a crucial role in forex trading by aggregating prices from various market participants like banks, market makers, and fellow traders. They showcase the most competitive bid and ask quotes on their platforms, drawing from this pool of prices. While ECN brokers also act as counterparts in trades, they differ from market makers in their settlement approach rather than fixed pricing. Unlike fixed spreads, ECN spreads fluctuate based on market activity, sometimes even hitting zero during peak trading times, especially with highly liquid currency pairs like the majors.
Direct Market Access (DMA) empowers buy-side firms to directly access liquidity for securities they aim to buy or sell through electronic platforms offered by third-party providers. These firms, clients of sell-side entities like brokerages and banks, maintain control over trade execution while leveraging the infrastructure of sell-side firms, which may also function as market makers.
Straight Through Processing (STP) represents a significant leap in trading efficiency, transitioning from the traditional T+3 settlement to same-day settlement. One of its notable advantages is the reduction of settlement risk. By expediting transaction processing, STP enhances the likelihood of timely contract settlement. Its core objective is to streamline transaction processing by electronically transmitting information, eliminating redundant data entry and enabling simultaneous dissemination to multiple parties when necessary.
Choosing a Broker
When selecting a forex broker, it's essential to not only consider the fees, but also regulatory compliance, trading platform, and customer support. Look for brokers regulated by reputable authorities such as the Financial Conduct Authority (FCA) in the UK or the Commodity Futures Trading Commission (CFTC) in the US.
Here at Fusion Markets we’re dedicated to offering a quality service with an affordable fee structure. You can learn more about trading forex or view our licences.
Setting Up Your Trading Account
Once you've chosen a broker, the next step is to open a trading account. This typically involves completing an online application, submitting identification documents, and funding your account. Forex brokers offer various account types to suit different trading preferences, including standard accounts, mini accounts, and demo accounts for practice trading.
Identify Your Trading Style
Before developing a trading strategy, it's essential to identify your trading style, whether it's day trading, swing trading, or position trading. Your trading style will dictate the timeframe you trade on and the types of setups you look for in the market.
Below are the types of pros and cons of each trading style:
Types of Analysis
Fundamental Analysis
Unlike technical analysis, which primarily relies on historical price data, fundamental analysis examines economic indicators, monetary policies, geopolitical events, and other macroeconomic factors to gauge the strength and direction of a currency's movement.
Central to fundamental analysis is the understanding that currency prices are ultimately driven by supply and demand dynamics, which in turn are influenced by broader economic conditions. For example, factors such as interest rates, inflation rates, GDP growth, unemployment levels, and trade balances can all impact a currency's value.
One of the key concepts in fundamental analysis is interest rate differentials. Central banks use interest rates as a tool to control inflation and stimulate economic growth. Currencies with higher interest rates tend to attract more investors seeking higher returns on their investments, leading to an appreciation in their value relative to currencies with lower interest rates. Traders closely monitor central bank announcements and economic reports to anticipate changes in interest rates and adjust their trading strategies accordingly.
Another important aspect of fundamental analysis is the assessment of economic indicators. These indicators provide insights into the health of an economy and can influence currency prices. For example, strong GDP growth and low unemployment rates are typically associated with a robust economy and may lead to appreciation in the currency. Conversely, high inflation or rising unemployment may weaken a currency.
Geopolitical events can also have a significant impact on currency prices. Political instability, conflicts, trade tensions, and other geopolitical factors can create uncertainty in the market and cause fluctuations in currency prices. Traders must stay informed about geopolitical developments and assess their potential impact on currency markets.
While fundamental analysis provides valuable insights into the long-term trends and direction of currency markets, it is important to note that currency prices can also be influenced by short-term factors and market sentiment. Therefore, traders often use a combination of fundamental and technical analysis to make informed trading decisions.
Technical Analysis
Technical analysis involves studying historical price data and using various charting tools and indicators to identify patterns and trends. Common technical analysis tools include moving averages, trendlines, and oscillators like the Relative Strength Index (RSI) and Moving Average Convergence Divergence (MACD). Traders use technical analysis to make short-term trading decisions based on price action and market momentum.
Technical analysis is a cornerstone of forex trading, offering traders a systematic approach to interpreting market dynamics and making informed trading decisions based on historical price movements and market statistics. Unlike fundamental analysis, which focuses on economic indicators and macroeconomic factors, technical analysis relies solely on price data and trading volume to forecast future price movements.
At its core, technical analysis is based on the efficient market hypothesis, which posits that all relevant information is already reflected in an asset's price. Therefore, by analysing past price movements, traders believe they can identify recurring patterns and trends that may indicate potential future price directions.
One of the fundamental concepts in technical analysis is that of support and resistance levels. Support represents a price level where buying interest is sufficiently strong to prevent the price from falling further, while resistance is a level where selling pressure is sufficient to halt an upward price movement. Traders use these levels to identify potential entry and exit points for their trades.
Example of support and resistance areas on EURUSD Daily chart
Another key tool in technical analysis is chart patterns, which are formed by the recurring movements of prices over time. Common chart patterns include triangles, flags, and head and shoulders formations. By recognising these patterns, traders attempt to predict future price movements and adjust their trading strategies accordingly.
In addition to chart patterns, technical analysts also utilise technical indicators to aid in their analysis. These indicators are mathematical calculations based on price and volume data and are used to identify trends, momentum, volatility, and other aspects of market behavior. Popular technical indicators include moving averages, oscillators like the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD), and trend-following indicators such as the Average Directional Index (ADX).
While technical analysis is a powerful tool for forex traders, it is not without its limitations. Critics argue that technical analysis is subjective and prone to interpretation bias, as different analysts may draw different conclusions from the same set of data. Moreover, technical analysis does not account for fundamental factors such as economic news and geopolitical events, which can have a significant impact on currency prices.
Despite these limitations, technical analysis remains an indispensable tool for forex traders worldwide. By understanding and applying technical analysis principles, traders can gain valuable insights into market trends and dynamics, allowing them to make more informed trading decisions and improve their overall trading performance.
Risk Management
Setting Stop-Loss and Take-Profit Orders
Stop-loss orders are used to limit losses by automatically closing a trade at a predetermined price level. Take-profit orders, on the other hand, are used to lock in profits by closing a trade when the price reaches a specified target. By using stop-loss and take-profit orders, traders can manage risk and control their downside exposure.
Position Sizing
Position sizing involves determining the appropriate amount of capital to risk on each trade based on factors such as account size, risk tolerance, and the probability of success. A common rule of thumb is to risk no more than 1-2% of your trading capital on any single trade to preserve capital and avoid significant drawdowns.
Your Strategy
Once you’ve determine what style of trading would suit you best, you now need to develop a strategy. There are thousands of different strategies out there so you have the choice of learning one from someone else, or developing your own.
Regardless, some common strategies include:
Trend Following Strategies
Trend following strategies in forex trading involve identifying and capitalising on established market trends. Traders employing this approach aim to enter positions in the direction of the prevailing trend, whether it's upward (bullish) or downward (bearish), and ride the momentum for as long as possible. These strategies typically utilise technical indicators, such as moving averages and trendlines, to confirm the direction of the trend and determine optimal entry and exit points. The goal of trend following strategies is to capture significant portions of a trend's movement while minimising losses during market reversals.
NZDUSD Daily Chart showing optimal entry points to go short during a bearish trend.
Range-bound strategies
Range-bound strategies in forex trading focus on exploiting price movements within defined ranges or boundaries. Traders employing this approach identify periods when a currency pair is trading within a relatively narrow price range, bounded by support and resistance levels. Instead of following a trend, range-bound traders seek to buy near support and sell near resistance, aiming to profit from the price being restricted to the range highs and lows.
USDJPY 15min chart with optimal buy and sell signals for a range-bound strategy
Breakout Strategies
Breakout trading strategies in forex involve capitalising on significant price movements that occur when an asset's price breaks through predefined support or resistance levels. Traders employing this approach wait for a clear breakout from the established range and then enter positions in the direction of the breakout, anticipating continued momentum in that direction. Breakout traders typically use technical indicators, such as trendlines, moving averages, and volatility measures, to identify potential breakout opportunities and confirm the strength of the breakout. The goal of breakout trading strategies is to capture rapid price movements and profit from the subsequent price trend.
Example of an opportune entry for a bullish breakout trade on EURUSD 4-hour chart
The key to developing a strategy that works for you is by studying the charts and thinking about what makes sense to you. If you think patterns make sense as they identify areas of consolidation which can lead to a breakout, then pattern trading could be a good fit for you.
It’s important for any trader to stick with their chosen strategy and not switch strategies every time they encounter a losing streak.
Maintain a Trading Journal
Keeping a trading journal allows traders to track their performance, analyse their trades, and identify areas for improvement. A trading journal should include details such as entry and exit points, trade rationale, risk-reward ratio, and emotional state. By reviewing past trades, traders can learn from their mistakes and refine their trading strategies over time.
Avoid Overleveraging
While leverage can amplify profits, it also increases the risk of significant losses. Avoid overleveraging by using leverage cautiously and only trading with capital you can afford to lose. A general rule is to keep leverage levels below 10:1 to mitigate risk effectively. The best position is cash. You should ensure you’re only taking the most high-probability set-ups that are in-line with your strategy.
Stay Disciplined
Maintain discipline in your trading approach by sticking to your trading plan and avoiding emotional decision-making. Avoid chasing losses or deviating from your strategy based on fear or greed. Consistency and discipline are key to long-term success in forex trading. Sometimes it’s best to walk away from the charts and come back the next day with a clearer head.
Manage Emotions Effectively
Trading can be emotionally challenging, with the potential for both euphoria and despair. Learn to manage your emotions effectively by practicing mindfulness techniques, maintaining a positive mindset, and taking regular breaks from the market. Remember that losses are a natural part of trading, and it's essential to stay resilient and focused on your long-term goals.
Be realistic with your expectations
Trading can be very lucrative, but it can also be very costly. Traders should be realistic in their expectations – what % will you aim for each month? How much are you going to risk? Risking 20% of your equity per trade will be great on winning trades, but it won’t take long for you to eradicate your entire balance on a handful of losses. Whereas risking 1% equity per trade will allow you to conserve as much capital as possible, whilst still gaining 1%+ per winning trade.
To continue your forex trading education, consider exploring the following resources:
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“It takes 21 days to form a habit and 90 days to form a lifestyle”.
Most of us have probably heard of that quote already. It sounds simple, right? Who would have thought that you only needed three weeks to build a habit?
Imagine how much better our lives could be after a year with plenty of good habits that we want to adopt.
Whether you want to improve your physical health or performance in the financial markets, adopting good habits is the way to achieve it.
Unfortunately, we’ve all heard the not-so-successful stories. A New Year’s Resolution falls off after three days, leading to an initially motivated person being the same as he was a year ago.
There are 52 weeks in a year. If it takes three weeks to build a habit, you should have formed 17 good habits by then. If only it was that easy!
Why is it important to build habits?
Your habits are your small, everyday actions and decisions, and the sum of your habits defines your life.
Good habits form the foundation for a good lifestyle. For example, exercising regularly and getting enough sleep are good habits examples. Conversely, bad habits build up to form a bad lifestyle. Eating junk food every day is an example.
Who you are and where you are right now is simply the outcome of all your habits. Your overall health is the result of your eating and exercise habits.
Your trading mindset and your performance in the financial markets are the results of your trading habits.
You’ll notice that the most successful traders don’t just make good trading decisions; they have good trading habits that form the foundation for their decisions.
But when you’re starting out, we think one simple habit to instill in yourself is one associated with your identity.
What are identity-based habits?
Identity-based habits are habits that are based on who we are or who we want to be.
Imagine a circle with two other circles inside it, like an onion with layers. In this case, we have three layers.
The outermost circle are outcome-based habits. In this circle, we focus on the what. What do I want to do? What do I want to happen? For example, an outcome-based habit could be, “I want to lose 5kg this month.”
The middle circle is performance-based habits. Here, we focus on the how. So in the same weight loss example, a performance-based habit could be changing your gym routine, your diet, or how often your workout.
The inner circle, the most important circle, is where identity-based habits are. Here, we focus on the who. Who am I as a forex trader? Who do I want to be? These are purely intrinsically based.
A person who wants to lose weight would adopt an identity of, “I am a person who moves more,” or “I am a person with a healthy weight and a healthy lifestyle. This is what a healthy person does, so I will do this, too.”
Identity-based habits go deeper than outcomes and involve your worldview, beliefs, and perception about yourself.
All three kinds of habits are connected with one another. Your identity influences how you do things. This, in turn, affects what you achieve.
The problem is, most of us are too concerned with outcomes. As a result, our habits fall off pretty quickly because we didn’t have the foundation.
Remember the New Year’s resolution example? Those people don’t usually achieve their resolutions because they focus too much on the results when they should be focusing on their identity first.
Identity goes far beyond just one’s lifestyle. Even politicians revolve their discussions around people’s identities (identity politics).
Who you identify as affects not just what you do but what you believe in and how you see the world around you.
How does having an identity benefit your trading?
Having an identity forms a solid foundation for your actions and your habits.
Imagine two forex traders with a fair amount of trading experience. For September, they set a target profit: $5,000.
The first trader does not have an identity; he just cares about the outcome. He looks at the $5,000 profit goal and focuses only on that. He analyzes each trade carefully, but there is no real consistency to it.
He gets frustrated every time forex trading results in a loss because it makes it harder to achieve his desired outcome.
On the other hand, the second trader has an identity. He identifies as a good forex trader. The $5,000 goal profit is not the real goal because he knows that it’s something that good forex traders have.
Instead, he focuses on being a good forex trader. He asks himself, “I am a good forex trader, and what does a good forex trader practice?”
From here, he studies not just the financial markets but also the best traders. He adopts a good trading mindset and trading psychology and starts to build trading habits. He does this not because he wants to earn a $5,000 profit but because he wants to identify with what a ‘good’ forex trader does, he thinks more in terms of systems than outcomes.
Who do you think will be more likely to reach their target?
Of course, it’s trader #2. He goes beyond focusing on the outcomes. He actually lays the foundation by building good habits and adopting the proper trading mindset. He does all this because he has an identity, something which trader #1 does not have.
Building identity-based habits for traders
To build identity-based habits, the first thing you should do is look inward. Don’t worry about outcomes just yet.
Instead of asking yourself, “What do I want?” You should ask yourself, “Who am I?” or “Who do I want to be?”
Instead of focusing on a target profit, start with your identity.
Do you want to be a successful forex trader? What do these people do that you can?
Successful forex traders usually keep a journal to track their successes and failures. They also keep a balanced lifestyle, are aware of their biases, get enough sleep, and adapt to change. There are plenty of other habits, but these examples are good for a start.
The best thing you could do if you’re starting out as a forex trader and reading this is to constantly ask yourself “What would a good forex trader do right now”? Would they be learning more about the markets or practicing on a demo or would they be watching Netflix? Simple questions to ask but the power of your life is determined by the power of the questions you ask yourself.
It would be good to adapt all these too, but remember you’re not adopting these habits because of what you want. You’re adapting these habits because of who you are.
Identity-based habits last longer and lead to more success because they involve a deeper part of you.
When you inevitably encounter setbacks and make mistakes, you won’t get too frustrated with yourself and make emotional, impulsive decisions because you know that your habits are in the right place.
Albert Einstein was once asked what the most powerful force in the universe was. After a thoughtful pause and not without a sense of humour, he replied that it was compound interest, which he would later describe as being the world's eighth wonder.
If we were looking for a candidate to fill the number nine spot on that list, we could easily pick another innovation from the world of finance; leverage.
If we look at a dictionary definition for the term, we find the following.
"The use of credit to enhance one's speculative capacity"
The concept of financial leverage is probably most familiar to us in a mortgage loan, a loan secured against a property.
To secure a mortgage, it’s normal for the buyer or buyers of the property to put down a deposit that acts as their “skin in the game”.
A bank or other lender finances the purchase price balance through a loan that runs over a fixed term, usually measured in 25-30 years.
This is made at a known or referenced rate of interest, which may be fixed or variable over the loan term. For example, the rate may be set at central bank base rates +X%.
The buyer of the property finances the loan through the payment of interest, which compounds over time to make the lender a healthy return on their loan, assuming all goes well.
The ever-present longevity of a mortgage and the nature of its commitment can be summed up through a literal translation of the word mortgage from the French, where it means “death pledge”.
Of course, that rather sombre definition only looks at the liability side of the transaction. It doesn’t take into account the opposite side of the coin, and that is the asset that the mortgage is taken out over.
All things being equal, the asset will have appreciated over the lifetime of the loan. And in modern times, it will have often done so to such an extent that its value now exceeds the loan's original value.
Under those circumstances, the death grip is loosened and may even be released completely if the property’s owners choose to sell it and repay the outstanding mortgage balance.
That’s all very interesting, but what has any of this got to do with trading and investing?
Well, just over 20 years ago, traders in London had the great idea to introduce leverage into OTC financial instruments such as CFDs and rolling spot FX.
This effectively democratised the availability of leverage in trading by providing it to the man in the street who could now gear up their trading account and speculate on the markets in a way that wasn’t possible before this point.
The availability of leverage in margin FX and CFD trading was a marketing team's dream. A whole new industry sprung up to offer these products (which had previously been the preserve of hedge funds) to retail traders.
Eventually, competition for that business was such that brokers began to raise the levels of leverage that they offered to their customer base.
Put simply, that meant that traders could control an ever-larger parcel of stock, an equity index or FX pairs with a smaller and smaller deposit, which brings us to today.
It all sounds great. Because, of course, if your position was leveraged 500 times, then so was your P&L. A dollar profit became 500 dollars.
Well, not so fast because leverage is a two-way street that magnifies profits and losses.
And whilst leveraged positions in profits create equity in your account, leveraged positions that are in loss eat away at your account balance and ultimately undermine it completely.
Events in the spring of 2021 highlighted exactly why traders need to respect and control their use of leverage, and the consequences of not doing so could not be clearer.
Bill Hwang of Archegos Capital Management, a hedge fund turned family office with $20 billion in assets, effectively evaporated overnight thanks to a combination of risk concentration and excessive leverage.
Put simply, the fund had too much money chasing too few positions.
You might have thought that having $20 billion to invest would mean that you wouldn’t need access to leverage, but Archegos Capitals strategy was to leverage that vast sum by as much as 7x times through a network of banks and brokers. The trick was that none of these banks knew just how much leverage the other parties had offered Archegos.
But no one, not even a hedge fund of that scale, is bigger than the markets, and when some of these positions fell in price and value, the fund’s brokers asked for additional margin to shore up its trading accounts.
By this stage, the banks were concerned about their own liabilities and whilst they were talking to each other about they should proceed, one or two of the banks started to try and close out the positions they held for the hedge fund.
Once word got out that this was happening, it became a free-for-all, and the stocks that Archegos held plummeted. And that, of course, created even larger margin calls that the fund had no hope of meeting.
Below is Archegos' biggest positions in their fund and how quickly things folded within a couple of days after the music stopped. ViacomCBS, a respected US media company, fell by over 50% in 2 trading sessions.
These events reinforced another lesson for traders - the one that says the end of the party is never pretty if everyone heads for the exit simultaneously.
It also reminded us of how an imbalance between supply and demand can influence prices (Gamestop or AMC, anyone?)
You probably haven’t got $20 billion, but you do have your nest egg and trading capital that you worked hard to build up. Please don’t blow it by leveraging and concentrating your risk in one or two big positions.
A disciplined approach to money management and risk is the key to successful trading and investing. When you don’t use that disciplined approach, it often goes horribly wrong, as the former Hedge Fund Archegos Capital found out.
That’s a question that has dogged professional investors for years.
Picking investments or trades to buy is one thing but when it comes to selling and in particular timing a sale its a whole different ball game.
In retail trading circles, this can cause us to snatch at profits and to run losing positions beyond the point where our money management rules tell us we should have closed the trade, with predictable results. It's a clear form of loss aversion (a cognitive bias that we should all be aware of) that stops us from making the rational call to close the trade.
Success in trading comes from running profits and cutting losses to grow our capital base and the ability to do this repeatedly, over as long a period as we can manage.
Having trouble selling isn’t confined to private investors, however. It’s a real issue among professional traders and money managers, unlike the science of buying or investing, which has been scrutinised to death by academics, analysts, traders and other financial markets participants. The science (or should that be the art of selling or divesting) has had precious little coverage in comparison.
The widely respected Barons magazine recently highlighted the asymmetry in professional money managers' selling ability and why professional can vastly underperform the market benchmark.
A research paper written by a mixture of US academics and specialists who measure investment performance or “skill “ as they like to call it, looked at 4 million trades made by money managers between 2000 and 2016 across 800 portfolios that on average contained more than USD 570 million of assets (aka "smart money").
The researchers found clear evidence of skill when entering trades or positions on the money managers' part, but it was a completely different story when it came to exiting trades.
In fact, the research found that the money managers were frankly shockingly poor when it came to timing sales, selecting what to sell and when to sell it. The researchers estimated that this lack of selling ability cost the managers returns of 2% per annum. Whilst that might not sound like much in insolation, if we consider the effects of compounding over decades that underperformance becomes hugely significant.]
That point is further reinforced by research by asset managers at JP Morgan Chase in 2014.
The fund managers looked at the lifecycle of 3000 US stocks dating back to 1980 what they found was striking as the quotes below show.
Risk of permanent impairment
“Using a universe of Russell 3000 companies since 1980, roughly 40% of all stocks have suffered a permanent 70%+ decline from their peak value.”
Negative lifetime returns vs the broad market.
“The return on the median stock since its inception vs an investment in the Russell 3000 Index was -54%. Two-thirds of all stocks underperformed the Russell 3000 Index, and for 40% of all stocks, their absolute returns were negative.”
Trades have a finite life cycle, and for the vast majority of stocks (or choose your asset class), they will often have their moment in the sun, get too close to it, and then fall away, never to return to those levels again. Identifying trades at their peak or going past their “sell-by dates" couldn’t be more important to an investment portfolio's performance.
In light of this knowledge, what can we do?
As with all the biases and psychological blackspots in trading that we discuss in our articles knowing and acknowledging that they exist half of the battle because we can modify behaviour accordingly once we have done that.
As traders in cash-settled margin products, we have an advantage over the money managers and asset owners described above. Simply because we are used to going both directions, e.g. shorting, on asset classes such as currencies and metals.
We take a 360 degree or holistic approach to the markets and the skills we use to decide to short USDJPY or the US 500 index can also be used to determine when a long position has run its course. Conversely, the skill set we use to identify a trading opportunity on the long side should also tell us when a short position is running out of steam.
Most traders we know of at Fusion do not hold their trades for more than a couple of days. Due to the power of leverage, they often don't need to since the gains can be enormous (but so can the losses we leave to run far longer than any positive P&L).
At the same time, why not make use of take profits or trailing stops to make sure you can squeeze that little bit extra out of the profit on the trade or set your levels and stick to them, without checking your phone or platform every minute of the day as we all do.
By adapting our mindset and the trading skills that we developed around opening trades, we can become better sellers or closers of positions and that will help us get the most out of the trades we make and the positions we take.
Or why we tend to rely heavily upon the first piece of information we receive.
Our minds can have an enormous impact on our trading and the returns that we generate from it. The way we think, act and behave when we trade or invest is at least as necessary if not more so than our trade selection, particularly in the kind of one-way markets that we have seen post the covid crash.
A rising tide lifts all ships they say, and, in this case, the rising tide of the markets was provided by the printing presses of the major central banks along with the stimulus packages from national governments.
However, Central banks won't always be there to rescue us and we need to be aware of the kind of tricks that our brains can play on us if we are to avoid making the wrong trading decisions.
One of these tricks has a nautical moniker, anchoring, in which our brain subconsciously latches on to an idea, an assumption or a set of figures and uses that information in decision making, regardless of whether it's accurate or even relevant to the matter at hand.
What's more, as humans, we tend to carry these impaired decision-making processes forward so that we end up using an inherently flawed system and often without realising it.
Behavioural psychologists have highlighted these tendencies in their experiments.
In the case of anchoring American academic Professor Jay Edward Russo performed tests on 500 graduate students in which he asked them pairs of questions on history and general knowledge, but, unknown to the students, he had "salted "the questions with erroneous dates and figures.
The student's answers invariably reflected the incorrect numbers, which were varied across different groups of students within the experiment, highlighting a clear bias.
Professor Russo was effectively projecting those values into the student's subconscious, creating an anchor point.
When we become anchored to figures or a plan of action, we filter new information through that framework, which distorts our perception and decision making.
This can even make us reluctant to change our plan or framework even if the situation calls for it.
There are few consequences if any when this happens in an experiment inside a university psychology department. Still, if it happens in the real world like in trading or investing, then there most certainly can be consequences.
Anchoring Bias has been described as one of the most robust effects in psychology, the fact that our decisions can be swayed by values not even relevant to the task (or trade) at hand.
Let's say we are negotiating the purchase of a house and I tell you it's worth $1,000,000, and I wouldn't sell it for less. You, as the willing buyer might have only had a price of $800,000 in your head. But all of a sudden, you now are anchored on my price. Not yours. The worst part is that the person who goes first in the negotiation tends to anchor the other party (remember this for the next salary negotiation you need to do with your boss!)
The studies even show that if you rolled a pair of two dice, gave the numbers (e.g. 10 and 19) to the study participant, that subconsciously, you would anchor them on these two numbers. Ask them what they would pay for a house, bottle of wine, or in one notorious study, the judges sentencing a criminal, these numbers are in and heavily influencing the participant's decisions whether they like it or not.
Anchoring always occurs in making our trading decisions, especially as it might help to explain our fixation with round numbers. E.g. EURUSD at 1.20. Gold at $2000/ounce. DJ30 - 30,000. Once we get hooked on the number, we always use it as a reference point in future, probably because it "feels right".
Let's say in the past you might have successfully gone long EURUSD at 1.20 earlier in the year, and now whenever it comes back to that number, you will buy it again (the same thing happened to EURUSD at 1.10). You can't explain it, but you had past success with that number and you will gravitate towards it without understanding why.
Take a moment to consider some key support and resistance levels on your favourite instruments. Are they round numbers too? Why might that be? Could it be because people are anchored at Gold at $1900? And that every man and his dog has placed their buy orders at that level because it's "good value" or has spent time around that level in the past? Remember that the market is driven by sentiment and agreed upon narratives. Think what else could the crowd be anchored on that might be to your advantage knowing what you know now.
How do we avoid being anchored?
Given that we don't completely understand the processes that cause anchoring to happen in the first place, we are unlikely to avoid it entirely.
However, by being aware of its existence, we can revisit and retest our assumptions when making important decisions, to ensure that we are acting rationally and basing our decision on the situation at hand, not irrelevant inputs.
Perhaps the best way to avoid anchoring in trading is to treat every trade as an individual event and to judge a trading opportunity on its current merits. By doing this, you have a better chance to ignore any reference or prior interactions you have had with the instrument you are trading. It won't be easy to do at first, but it could prove to be a valuable discipline over time. As mentioned, this is crucial to comprehend for putting your stops and limits around key support and resistance levels.
Think about a time you have been fixated on a number. Was it buying a house? A pair of shoes? Trading? Now think whether that number could have been influenced by someone else, e.g. the seller, the shoe store etc.
Anchoring can certainly also play a part in other hidden biases and behaviours such as loss aversion (e.g. not wanting to close your open losing trade).
The next time that you are about to trade, take time to think about why you are fixated with that number for entering and exiting the trade, and how you reached the decision to pull the trigger. A few moments of reflection might make all the difference.
