Sleepless nights are a common predicament for most traders. It is the only time you are not consciously screening the markets. As stressful as it can be to sleep with volatile open positions, it is extremely important that you beat the urge to make impulsive moves and that you give your brain some rest.

Since the forex markets run 24/5, most people barely get enough sleep while the markets are open. But this kind of lifestyle will ultimately lead you to make sub-optimal biased trading decisions.

Depending on which part of the world you’re in, the markets might move the most while you should be asleep. For those here in Australia, we are sleeping while the US is in their trading day, which, when you have large open positions active in the market, can make it even more difficult to get a good sleep.

But here’s the thing most traders are not thinking about. Getting a good night’s sleep every day is just as crucial as your fundamental and technical knowledge. Still, many of us tend to overlook a good rest, thinking we can survive on far less than we need. Let’s look at why sleep is essential for forex trading and how to cultivate a good sleep routine.

Why is sleep important for traders?

Sleep plays a big part in our mental wellness, which then affects our decision-making for the day.When you’re placing trades that involve vast amounts of money along with prices that change every second, you want the part of your brain that makes decisions (the pre-frontal cortex, if we’re being precise) to be in tiptop shape.

Ask any elite athlete what one of the most essential tools they have for recovery is, and it’s often sleep. Lebron James, for example, reportedly sleeps as much as 10 hours a night. Now I know what you’re thinking, “Well, I’m not an elite athlete and I’m certainly not Lebron”. But you are trying to obtain peak (trading) performance, right?

Trading involves competent risk management. Before you execute those trades, you want to have a clear picture of the risks and benefits so that you can make calculated and well-informed decisions. When you don’t allow your body and mind to rest well, your practical decision-making is overshadowed by restless behavior patterns.

Basically, good sleep keeps you sharp and productive. On the other hand, studies show that lack of sleep tends to impair decision-making involving complex factors and unexpected occurrences, which occurs quite a lot when the markets are open. By having good sleep regularly, you allow your brain to make unimpaired decisions compared to when you are sleep-deprived.

And speaking of the brain…  

What’s the science behind it?

First, let’s look at what goes on in your brain when you sleep.

Throughout the day, when you’re awake, the brain accumulates metabolic waste. You don’t even have to exercise or move around to accumulate it. Your body already expends energy by just keeping your basic functions running, like breathing and pumping blood.

In using energy, metabolic waste builds up in various parts of your body, your brain included. In time, the buildup can interfere with the peak functions of your brain. When you sleep, your brain sees the perfect opportunity to do some house cleaning. The brain has a built-in waste removal system which is called the glymphatic system.

Sure, the glymphatic system also works while you’re awake, but the cleanup process is at least twice as fast when you’re asleep. This is because your brain knows that there’s not much going on in your body, which allows it to focus on clearing up.

This is why you always feel refreshed and focused when you wake up after a good night’s sleep. And since mental wellness plays a huge part in your trading psychology and your trading mindset, you always want to be in this “clear” state whenever you’re trading. When you’re sleep-deprived, the part of your brain in charge of your fight or flight reactions — the amygdala — is far more stimulated than it would be when you’ve had a normal amount of sleep.

What does this mean for you as a trader?

Well, try to go back to the last time your fight or flight reaction (or amygdala hijack) got triggered. Maybe you were in a disagreement with a colleague or a friend, or you were in an emergency. Wasn’t it hard to stay focused because you felt like a thousand things were going on at once? Now think about how you feel when you’re sleep-deprived and a trade isn’t going your way and a new announcement means you need to think about the implications and what’s next for the market. Are you at your best cognitively at this point? Probably not.

A stimulated amygdala makes it hard to make logical decisions. It also cuts off access to your pre-frontal cortex, which is in charge of making logical decisions. And as forex traders, our trading mindset should always be governed by logical, not emotional, decisions.

Unfortunately, your brain is more likely to go into fight or flight mode with a lack of sleep. You aren’t thinking or seeing the market clearly. Maybe you’re paranoid about your trade, or you see things that aren’t there, or maybe you enter or exit the trade too early.
  

How does a good night’s sleep benefit your trading?

A good night’s sleep gives you good preparation for the trades you’ll be making the next day. Your brain is clearer, and your mind is sharper. When you look at the charts, you’ll be less likely to be influenced by sudden price fluctuations, which we know are all too common in financial markets, particularly in forex trading.

By consistently making good forex trading decisions, you’re more likely to see bigger gains in your trades.

In fact, one study  suggested that sleep-deprived forex traders had relatively lower returns because their decision-making skills were affected.

A good night’s sleep also promotes a healthy work-life balance. You may be a forex trader, but it’s also important to look into your personal health outside the financial markets. You feel more energized and alert when you are awake, allowing you to see new opportunities in the market that an otherwise tired trader might not. This could be your edge.  

Tips for sleeping better

Now that we’ve talked about why sleep is important, let’s talk about developing good sleeping habits.

First, reduce your screen exposure before bedtime. Blue light keeps our brains alert, and this is the kind of light that you usually see from your phones and your living room lights.

Put the phone down and shut off your computer. As hard as it is, that will mean trying to keep your eyes off the charts. Try having herbal tea (Peppermint, chamomile is best for relaxing), reading a physical book (to avoid more screentime), or doing something that relaxes you to get your brain ready for bed. If you really must check your phone or computer late at night, try using apps that make the screen appear “warmer,” giving it an orange tint or via “dark mode” starting from a couple of hours before your bedtime.

Orange lighting is less harsh compared to blue light, which makes it easier to eventually fall asleep.

Second, if you can afford it, separate your workspace from your bedroom. You want your brain to associate your bedroom with rest and relaxation so that as soon as you walk into the bedroom, your brain “gets” it and starts powering down. Playing on your phone or laptop in bed is likely confusing your brain.

Third, keep your room to a cool temperature. Ideally, between 18-20 degrees Celsius.

Finally, one of the worst things you can do is get up and check your phone or computer for what’s happening in the market. The screentime on your eyes, the adrenaline rush, and more will only cause you to make an emotional decision.

If it makes you feel better, a stop-loss or a take profit takes a lot of the unknowns out of the equation. Your trade will either have one of three things happen: It’s still open, it’s been closed with profit, or closed with a loss. By leaving the outcome to the market, you are more likely to think too heavily about it all through the night.

Forex trading is not all about the technical and analytical aspects. A sound body complements a sound mind. You should take care of both aspects to make sure you are at your best. In our view, a well-rested trader will likely exceed a sleep-deprived trader that’s not at peak cognitive performance.

In trading, as in life, we are faced with the need to assess complex situations and quickly make judgements or decisions. And in both cases, we can’t be certain what the outcome of those snap decisions will be. Though we have to deal with the consequences regardless, even if they don’t reveal themselves for some time.

I wonder how many of us look back at the choices we made and judge them solely by the outcome they achieved, be that good or bad, rather than looking at how we got to that endpoint?

Behavioural psychologists believe that if we look at events purely in terms of their results, we are under the influence of outcome bias and as such we are likely to have a flawed view on risk and reward.

That outlook has been famously summed up in the phrase “picking up dimes in front of a steam roller” which has been variously attributed to Nassim Taleb and or economists Martin Wolf/John Kay.

Whoever coined the term (no pun intended) got it just right, because if you are picking up those coins then yes you are acquiring money, but you can only afford to slip up once and then it will be game over, and in a very messy way.

Another renowned economist, John Maynard Keynes, wrote on the subject of risk-reward and outcomes, just over 100 hundred years ago, in his treatise on probability.

Where Keynes thinking differed from traditional schools of thought was that he believed that an event could be, what he called, objectively probable, even if it didn’t actually take place. And that it would remain so even if you were looking back at events at a future point in time.

For Keynes, it was more important to be rational in your decision making than to be right.

Keynes of course also famously said that “the markets can remain irrational for far longer than you can remain solvent “  

That is one of my favourite quotes on investing. It neatly sums up the practicalities of being rational versus being right, as far as a trader is concerned - Being right doesn’t necessarily make you money and in fact, even if you are right waiting for that to be proven could cost you a fortune.

Whereas being rational or pragmatic, and acknowledging that the market is “directionally right “ but for the wrong reasons (which is usually the sheer weight of money) is one thing. But then trading with the market until the point when the crowd realises their folly, is likely to be a more profitable approach in the long term.

After all, by adopting this approach you don’t have to time the market at all instead you just need to watch for the points at which the crowd turns. And to that, we can use momentum and sentiment indicators, which you can set up in advance.

In short, when it comes to trading at least, the process is more important than the outcome.

The British military has a saying which runs as follows: Failing to prepare is preparing to fail.

As a trader it’s hard to fault the logic in that statement, because if we believe that there is a symmetry between risk and reward, inputs and outputs, effort and results, and in trading where there must be a loser to offset every winner, why wouldn't you believe that?

Then if we don't prepare properly for each trade we make; we are not giving ourselves the best possible chance of making money.

We often say that a systemised approach to trading is the best one to adopt. What we mean is that we should have a framework of rules that we follow in each trade we make.

And we don't let our hearts rule our head or worst of all let our egos’ fools us into thinking that we have some special insight our secret trading sauce. Because in 99.9 times out of a hundred that won't be even remotely true.

Talent and luck will carry you only so far and many a sportsperson has built a successful career by recognising their own abilities and limitations, and then working hard to improve their technique and approach.

And in turn in recognising the weaknesses in their opponents game, which they can then exploit.

The opponents may still score against them but if they are reducing the rate at which they can score then they are doing something right, and they are slanting the odds of a positive outcome in their favour.

In trading, you won't win every contest but if you win more than you lose and have bigger wins and smaller loses, then, over the long term you will definitely come out on top.

That’s a good question and is one that was posed by a man with many years of experience in the markets, Charley Ellis. Ellis, after a stint on Wall Street, founded Greenwich Associates in 1972 which grew into one of the world's most respected research houses. He said:

“Go to a continuous-process factory sometime — a chemical plant, a cookie manufacturer, a place that makes toothpaste. Everything is perfectly repetitive, automated, exactly in place. If you find anything interesting, you’ve found something wrong.

Investing is a continuous process, too; it isn’t supposed to be interesting. It’s a responsibility. If you go to the stock market because you want excitement, then sooner or later you will lose. Everyone who thinks the stock market is a game loses — everyone, to the last man, woman and child.

So, the purpose of an investment policy is simply to ensure that your continuous process never breaks down...

Benign neglect is the secret to long-term investing success. If you change your investment policy, you are likely to be wrong; if you change it with a sense of urgency, you’re guaranteed to be wrong.”

There is a lot of sense in those comments after all the key to successful trading is finding a system, trading style or approach that works for you, and does so consistently.

Developing or creating that approach gives you your edge, which is something that every trader needs if they are to succeed and grow their capital long term. Creating a viable trading strategy or trading edge is the exact opposite to the random and emotional trading that sees many new and aspiring traders come to grief early on their career.

When we read about great traders, we often wonder what makes them different to you and me and what it would take to follow in their footsteps. Let’s be honest we probably aren’t going to be the next George Soros, Ray Dalio or Jim Simons. However, what we can do is to emulate their systematic approach to the markets.

Systemising your trading is about creating a set of rules which describe your trading approach, the opportunities you look for, and the risk management ratios you apply.

Once you have written these down, you have effectively created your trading plan, and what’s more, you have laid the groundwork for creating an algorithmic strategy.

An algorithm or algo is just a set of rules that a computer can follow and execute. Of course, nearly all trading today is conducted electronically. Yet, as much as 70% of that business employs algorithms to improve trading efficiency, execution quality and anonymity. The latter can be beneficial in retaining your trading edge and not seeing it arbitraged away.

A report by Business Wire predicts that Algorithmic trading will experience a compounded annual growth rate or CAGR of 10% per anum between 2018-2026. Two years into that period, and there is no suggestion that the analysis is wrong.

Using a rules-based system to decide when you should buy and sell is the key to maximising your profitability. And perhaps just as importantly, minimising your losses. Leaving those decisions to our emotional selves is not a viable option for long term trading success.

As we have discussed before, our psyche contains biases, emotional responses and short cuts that are not suited to trading and they can actually hinder the process. It’s far better to use a systematic rules-based approach that can help us run winners and cut losses rather than the other way around.

To take your trading to the next level, you need to ask yourself a question, and that is...

Have you developed a system, or are you just having a punt?

Do you follow a set of trading rules and stick to them each time you trade? Think about your trade sizes, risk-reward ratios, the use and placement of stop losses. Consider the average profitability of your trades and how often and by how much do the results deviate from that average?

Much of this data will, of course, be available to your in trade history and statements that’s one of the great benefits of electronic trading. It should be possible to identify the products you trade well and the time of day (your peak). Not to mention those times you switch gears and try to trade something you’ve never done before. E.g. an FX Trader dabbling into commodities because it’s “hot”.

A very effective way to systemise your trading and improve its efficiency is not to trade in the instruments, and at the times of day that you do poorly on. And instead, focus on the most profitable areas of your trading. You will be amazed at just how much difference that simple change could make.

Finally, ask yourself, are you getting too excited about your trading and the individual positions that you take? Do you wake up in the middle of the night dreaming about your positions or checking them? If you are, then you are probably taking too much risk.

You see a trader should largely ambivalent about individual positions, because if he or she has systemised their process, then trades will be a bit like riding the tube in London, that is, another one will be along in a minute.

What will or should be of concern to them, however, is whether they are making the most out of every trade that comes by. Better to be focused on the process and the system and not the individual trade outcomes. Transitioning from one way of thinking and approach to the other will very much put on the right route for trading success.

That's just the way it is
Things will never be the same
That's just the way it is
...Some things will never change

2pac - Changes

In modern life, our focus is often on change. We quickly assess something as either Good changes or bad changes.

Change is also the lifeblood of the financial markets which would, of course, be pretty dull if everything remained static and prices never moved.

However, the opposite is true in these days of computerised and algorithmic trading.

Prices are rarely static and fluctuate throughout the trading day, which blends seamlessly into the next business day across the working week, which may eventually extend into the weekend as well, but I digress.

As much as our lives are driven by or focused on changes, they are underpinned by many constants, things that don’t change over time no matter how much the world and our everyday lives do.

Information

One of the constants today is information, inside thirty years, the internet and world wide web have become an integral part of our lives. To the extent that we can overload ourselves with information on almost any subject imaginable in seconds.

However, there is a big difference between having that information at our fingertips and understanding a subject or topic thoroughly, and it's very easy to conflate one with the other.

You can feel like an expert when in fact you may have missed the point entirely. Reading between the lines is often what's most important, and we need to recognise that we don't know as much we think we do and be comfortable with reconciling ourselves to that.

In trading, even in the information age, we can only ever hope to see a fraction of the big picture. The only comfort is it's exactly the same for almost everybody else.

If you think you really can understand the exact reason the market has gone up or down, think again. The financial media will say the market went up or down for the same reason. Could they ever admin something like: “There’s no story we could slap on this for why the market went up today. It just did”. No.

Greed and fear

Another constant in trading is the role of Greed and Fear these are the two primary drivers of investor behaviour, particularly when we are looking at that in aggregate.

That is, when we consider the trading crowd. The crowd has always been with us, journalist Charles Mackay wrote about them in his 1841 work Extraordinary Popular Delusions and the Madness of Crowds.

In the book, Mackay looked back to events in 1720, the South Sea bubble, and the Dutch Tulip mania of 1637, to highlight just how crowd behaviour, driven initially by greed and subsequently by fear, leads to the creation and bursting of investment/trading bubbles. If those bubbles become big enough then they can not only affect the markets but also the real economy too.

Speculation is as old as the hills and financial crises are nothing new. In fact, in modern times they have become cyclical, occurring around once every 10 years or so, for example, we had the 1987 crash, the Russian default and Asian currency crisis of 1998 and the subsequent dot com crash. That was followed in turn by the Credit Crunch and Global Financial Crisis of 2007/8 and more recently the COVID crash.

A decade is enough time for a new generation of traders to enter a market and each new generation believes that “this time it’s different” a phrase which is often described as being the four most dangerous words in trading.

Traders make the same mistakes and fall foul of the same biases and behaviour as their forebears did. It’s just that now there are scientific labels for it (we do love to put a label on something).

If you read trading books like the Reminiscences of a Stock Operator by Edwin Lefevre (first published in 1923) you instantly recognise patterns of behaviour regularly seen among market participants today.

Too much risk

One of those behaviors is taking too much risk or over-trading, relative to your capital base. That's often brought about because markets move in one direction for an extended period. People climb on board the trend, and the longer it goes on the more they believe it won't end and the greedier they get.

They don't deliberately mean to do this but one of the characteristics of bubble behaviour, because that's what this is, is the participants inability to tell that they are in a bubble. The narrative simply changes. When you’re inside the bubble you will cut off contact with or ignore those on the outside looking in or who have a different viewpoint or opinion.

Market aphorisms or sayings are grounded in the truth and experience of history they may sound quaint, but they are there to teach us a lesson, and none more so than

 “It's only when the tide goes out that you see who’s swimming naked”

In this case, the tide going out is the market changing direction and those swimming naked are the overleveraged and overlong bulls in the bubble. Markets crash because the trading crowd wakes up to the existence of the bubble simultaneously, and everyone heads for the exit at the same time, as greed turns into fear.

A good trader knows not to outstay their welcome, and that it is always better to leave the party before the end.

We’re not saying that markets don’t change and evolve over time and that a strategy you use will work forever, but the same fundamental principles like we’ve tried to highlight such as greed and fear never will.  Some things will never change.

Much of what we write about in these articles is about the mindset and behaviour of traders and trading. The reason for this is quite straight forward; it's because it's the decisions that we make and take that will ultimately determine how we perform as traders.

Yes, of course, price changes in the markets will play their part but, in the end, it's our decision whether to get involved or not and that determines how much capital we commit to trade, how long we hold the position for, and what the ultimate outcome of the trade will be.

Hidden costs

When we examine the costs of trading, we tend to focus on commissions and spreads and our PnL, but there are other costs, costs that we don't consider when really, we should.

These are the costs of inactivity and indecision, the costs of listening to outside influences more than to your own inner feelings and intuition. They are the costs of missing out, what economists call "opportunity costs".

Self-doubt among traders is not unusual, and in truth, it's better to exercise a degree of caution than to be 100% confident about everything you do. Hubris has been the downfall of many traders, and we certainly advocate being prudent with your risk. That said, It's always worth testing your thinking and assumptions and checking that they are still valid before you trade.

The problem comes when you start to talk yourself out of the trade entirely. After all, trading is a risk and reward business. There can be no profit without the possibility of loss.

A trader's job is to try and ensure that the risk that they take is in proportion to the potential rewards they could make. Not taking that risk could be limiting your potential as a trader which in turn may be limiting your rewards or returns.

Moments of clarity

Sometimes as a trader or investor, you will enjoy a moment of clarity, a moment of pure thought and insight, in which you can see exactly how a market setup or situation will playout. Moments when you just know you are right

If that moment of clarity coincides with significant moves in the markets, then that can be a very valuable situation indeed. But only if you act on it.

Allow me to tell you a personal story. During the great 2020 downturn in oil (where a Saudi/Russia price war caused prices to go NEGATIVE), I found myself holding oil from $30 a barrel and riding it all the way down watching in sheer horror. I kept buying the dip. How much lower could it go, I thought? I ignored every rule and everything I've written in the past about this. I didn't put a stop loss on. I told myself it was a long-term trade that I would stay in forever. Prices surely couldn't go below $20. That's madness. Then… The unthinkable happened in the futures price – it went negative.

Thankfully, Fusion's price didn't go negative (we use Spot Crude oil) but with spot prices at $15, I was sitting watching Netflix on my couch, and my heart raced as I saw it go down like World War III just started. The news sites told me nothing new had happened (funny how we search for any narrative to make sense of it all). Here it went. $14. $12. $11. Back to $12. Back to $11. $10. $9. Thoughtful me knew these prices were unsustainable. I told myself I would hold until it hit $0 if it had to. My account was down 70%. I'd never suffered such steep losses. I felt sick. I then couldn't sleep. I woke up, and it was still down a lot but had recovered from $7.

Watch out for the narratives.

I started to read more about what others were saying. What the hell was going on? Would this happen again? Yes, there was nowhere to store the oil (so the narrative went) but surely rationality would prevail. Seriously, how could you have negative prices? It was impossible to find anyone bullish in the media or otherwise. People assume if something just happened, it will occur again Goldman came out and said to expect more negative pricing. But I just couldn't believe it was so cheap. I knew it was time to buy more!

But then I didn't buy it. I waited for another opportunity for when I knew "the worst was over" I was so sure things would bounce back, but I didn't have the guts to buy one more time, and the opportunity passed me by forever. I let the external narrative cloud my previous judgement. But I was just so worried I couldn't think properly. Within days, it had doubled back to $15 a barrel. Then it was $20 a week later. At the time of writing it is $40 a barrel. By the time you read this, it might be $60 a barrel. Who knows? All I knew was fear and too much outside influence completely warped my view, and I failed. I just wanted to survive the calamity. While I survived to write you this, I did not do as well as I could have.

Self-belief

People often talk about having the courage of their convictions, but in trading, it's not really about courage, it's about belief, belief in yourself and your ideas and be prepared to back them, rather than talking yourself out of them, or allowing yourself to be talked out of them by others.

We all like to take advice and read and hear the opinions of so-called experts. But the absolute truth is that nobody really knows what going to happen next in the markets.

For example, nobody was predicting that an 11-year bull market in equities was going to end and end so abruptly in Q1 2020. Or that US unemployment would spiral to +14.7% in a single month.

Do not get me started on the rebound from the lows in March. To be bullish on the markets in April and May of 2020 was to look like you had lost your mind given the narratives surrounding COVID.

So-called "market legends" like Druckenmiller and Buffett told everyone it was not the time to buy. Sadly, so many would have listened.

Let's not forget Yogi Berra's famous saying "It's hard to make predictions, especially about the future" which is why it's best to take these so-called forecasts with a grain of salt. The best that any expert can do is to make a prediction or forecast about the future. And the longer the time frame that the forecast is over, or the more unusual the circumstances under which it is made, then the more significant the room for error and the higher the chance that they are simply wrong.

Loss aversion

As humans, we are subject to subconscious emotional biases that can cloud our decision making. One such bias is loss aversion.

Loss aversion can hamper a trader in two distinct ways. It's most commonly associated with the practice of running losses, ignoring stops and breaking money management rules when a trader can't or won't accept that they were wrong and refused to close a losing position.

The other way that loss aversion can muddy the waters is in our initial decision making. You see as species we are poor judges of risk and reward; we don't calculate probabilities very well, and the upshot of this is that we do not like uncertainty.

To the extent that when we are faced with situations that have a series of potential outcomes, we tend to favour the outcome with the highest degree of certainty. Even if that outcome is the least beneficial to us financially. Which, of course, is the exact opposite of the risk versus reward culture that we spoke about earlier.

Fortune favours the bold.

Though we might not like to admit it, our subconscious is often trying to talk us out of taking risks. Outside influences from the media, fear, our aversion to loss and a preference for certainty may often be our worst enemy as traders.

As Howard Marks said, "If you're doing the same thing as everyone else, how do you expect to outperform them"?

There have been several once in a generation trading opportunities over the last six months. I wonder how many of us were bold enough to seize the day and take advantage?

These are unprecedented times for all of us. Not only have we seen the financial markets crash, moving from an 11-year bull market into a bear market, with a -33% correction (only to see it bounce back up 25%!), in less than a month, but we have also seen the oil price collapse, thanks to a price war between two of its biggest producers and an oversupply. On top of which we have the small matter of the Coronavirus and associated lockdowns and isolation to contend with. What a time to be alive! 

Life has changed dramatically in the space of just a few weeks and things we took for granted can no longer be relied upon.

If you watched the way the financial markets have been performing over recent weeks you will have experienced a rollercoaster of emotions that has matched, if not exceeded the peaks and troughs of the market. What kind of market are we in? General fear and greed? Are professional Investors rushing to cash and dumping everything they can? Algorithms? Passive Investing/ETFs exacerbating moves? Everything and anything is being put on the table but these moves are unprecedented.

 If you're not confused, you're not paying attention. 

You‘ve probably been conflicted, part of you may have wanted to bury your head in the sand and hope it all goes away. Another part of you may have wanted to sell everything and “head for the hills” except (literally speaking) of course you can't because you are under lockdown.

Let’s be clear these are stressful times. Even hard-nosed professional traders who have seen market crashes before are in unchartered territory at the moment and are trying to work out what to do next.

And just like you, they have been behaving a bit like a rabbit caught in the headlights. That is, not sure whether to run or stay put.

Before we can decide what to do next, we need to take a step back and examine why we’ve been behaving and thinking as we have.

Firstly, we need to realise that it's not personal or unique to us. Everyone is stressed at the moment, they are out of their routine and under immense pressure. concerned for the wellbeing of families, friends and finances.

At times like these our everyday decision-making processes take a back seat and the way our brain and body operates undergoes subtle but important changes.

When we are severely stressed our blood chemistry changes dramatically, adrenalin, noradrenaline and cortisol are produced by and pumped around our bodies.

These chemicals increase our heart rate, our pace of breathing. and ready our muscles for action. Without us being aware of it we are preparing for fight or flight.

Why does this happen?

Well, the truth is that a prehistoric part of our brain is taking control of our actions. There are "Two-yous" in your brain. A rational, deliberate, thoughtful you. And an emotional, fast-thinking you.

The frontal cortex of our brain, which is the part of the brain that we normally use for decision making, becomes less active and a part of the brain that's sometimes referred to as our reptile mind, called the amygdala, takes over.

The amygdala is an almond-shaped cluster of neurons and nuclei buried deep in our brains, frankly, it’s a “throwback”.  It has its own independent memory systems and it deals with our emotional and physical responses to stress and fear.

The amygdala evolved to make us alert to danger and to keep us alive if, for example, we came face to face with a large predator. These days, for most of us, confronting a large predator, is a remote possibility.

However, the amygdala's response to heightened levels of stress and stressful situations have become baked into our brains thanks to millions of years of evolution. Such that it’s become part of our subconscious, and something we are only faintly aware of and are not able to control.

So if you have been watching the markets or financial TV recently and have felt your heart pumping, your brow sweating, your muscles tensing and have found yourself only able to focus on the screen, even ignoring someone who is speaking to you, in the same room, you are not alone or to blame. You only need to watch five minutes of television or visit a news site to see blaring counts of the death toll, economic shutdown and other news that puts your amygdala in the driver's seat.

When our reptile brain takes over our decision making becomes short- term and driven by fear and our long-term strategic thinking goes completely out of the window.

That's why it's so dangerous to make financial decisions under stress at the heat of the moment if you will.  A few rash decisions or actions that are taken then can easily undo years of hard work.

So how can we try and counteract these primaeval forces in our brain and psyche?

Well, the first thing to do is break the cycle, so walk away from the source of stress be it the TV or the computer screen and gather yourself. If you can get into the garden or get some fresh air for a few minutes that will help.

Having removed yourself from the situation you can try to re-impose some order.

Think about the timescales you are investing or trading over. If you are trading FX you may be taking short term positions, but they are likely to be part of a longer-term plan. Perhaps you can re-appraise this as a once in a generation buying opportunity?

Remind yourself what your investing goals are and over what time scales were you trying to achieve them.

I very much doubt your plan was about weeks or even months was it?

Your plans were probably conceived to play out over several years, weren't they?

It also helps to think about who you are investing and trading for and why.

Perhaps it's for you and your family or other loved ones, thinking about these long-term goals can help you centre yourself once more. When I'm investing or trading I think about 65 year old me retiring and ask myself "Will I care about today's trading result then? Or even in one year?"

If you do need to make a decision or take action on your portfolio, try to make that decision when the markets are shut and you are free of distraction. You will find that you can think a lot more clearly in those circumstances. That clarity is only likely to benefit your finances over the longer term. Take a minute to take some deep breaths.

Remember, this too shall pass.

On Why making money on your first few trades may not be the best outcome

 

“The potential for temporary success by pure luck beguiles people into thinking that trading is a lot easier than it is. The potential for even temporary success doesn’t exist in any other profession.

 If you have never trained as a surgeon, the probability of your performing successful brain surgery is zero.

 If you have never picked up a violin, your chances of playing successful solo violin in front of the New York Philharmonic is zero.

It is just that trading has this quirk that allows some people to be successful temporarily without true skill or an edge—and that fools people into mistaking luck for skill”

- Quote from "What I Learned Losing a Million Dollars" by Jim Paul and Brendan Moynihan

Luck or skill?

The quote above, which is from the true story of the rise and fall of Jim Paul, sums up trading. It’s an occupation that you don’t need any specific qualifications to pursue.

However, unlike most “unskilled“ roles, the potential rewards in trading are substantial. In fact, they are open-ended or without limit if you prefer.

Of course, the key word in that sentence is potential because until they are realised those rewards will remain out of reach, tantalisingly close but just beyond our grasp.

Realising those rewards and doing so regularly will usually require hours of dedicated study and application, combined with the ability to follow a set of rules and the discipline to apply them every time you trade.

There is an old saying among traders and gamblers that they “would rather be lucky than good”, but this is wrong because as Messrs. Paul and Moynihan point out, people are very quick to mistake luck for skill.

Falling into a trap

To do that is to fall into the trap of outcome bias that is judging the success of an event or action purely on the results generated, rather than the journey taken to get to that endpoint.

Annie Duke, the famed poker player and author of “Thinking in Bets” calls this “Resulting”.

Yes, trading is about making money, but more importantly, it’s about making money without taking on excessive risk. It's all well and good picking up nickels and dimes you find in the street, but you wouldn't (or shouldn't) want to do this in front of a steamroller.

The ability to recognise, measure and quantify risk is a key skill for any would-be trader. Unfortunately, it’s a skill that must be learned the hard way, which in trading means losing money.

Harsh lessons

Losses are a fact of life in trading. They are part and parcel of the job description, and the trader must come to terms with that, and the sooner the better.

Here's the thing. In an ideal world, those new to trading should experience several consecutive losing trades. They should feel the pain and disappointment of seeing their money disappear and their ideas going up in smoke, however, by learning from their experiences, they should go on to be a better trader.

This may sound harsh, but there is no substitute for having skin in the game and losing money. It focuses the mind like very little else.

If we have correctly approached the markets from the outset (that is, conservatively), we should be risking only a small portion of our capital on any one trade, and only having a limited number of trades open any one time. Then these losses will be akin to scratches and scrapes and not mortal wounds.

A biased picture

Therein lies the crux of the dilemma we face as traders. If you are lucky and you make money straight away from your first few trades, you can develop a false sense of security.

You will overestimate your own abilities and fall victim to another bias, that of anchoring.

When our mind tricks us into anchoring, we carry an incorrect assumption or set of assumptions forward into future decision making. In turn, this can lead to availability bias where you make decisions and form opinions, based solely on the information in front of you, rather than considering the bigger picture.

To put this into context, let's imagine that you start trading in the live markets and you are fortunate to have US$ 10,000 in your account.

For your first trade, you take a “flyer” by going long two lots of an FX pair (that's US$200,000 of underlying notional value) You trade without a stop loss and then you head off for nine holes on the golf course.

By the time you return to your desk, the markets have shifted after a key central bank announcement.

By complete chance, because that's what it is, the markets have moved in your favour and you close out your position for a tidy profit.

That might sound like a good day's work, but it’s a disaster or at least a disaster in the making simply because you broke so many rules around money and risk management.

You didn't consider the leverage involved in the trade, the relative size of the position to your account balance and by not having a stop loss on the trade, you put all your trading capital at risk.

Finally, you didn’t check the calendar to see if any key data was due out and you left your position unattended while you played golf.

Make money but in the right way

We are not saying that we want you to lose money, on the contrary as your broker we would like your account to grow and for you to recommend us to your friends and family.

Ideally, as your partner in the markets, we want you to make money in a sustainable, systematic and thoughtful fashion, one that rewards best practice and encourages good habits, not bad. A trader placing small trades across ten years is worth far more than an easy-come easy-go trader who treats it like a visit to a casino.

A little discomfort in your first few trades can go a long way to achieving just that.

“That which does not kill us makes us stronger” – Friedrich Nietzsche.

It’s a cheesy quote to start with, I know. Bear with me here.  

It turns out it might be true when it comes to professional success as well.

In a recent paper published in the journal Nature, researchers found out that early-career setbacks can result in a stronger career in the long term – stronger even than people who never had a setback.

To sum up the paper in just a few lines, the experiment compared two groups of scientists: a group that scraped over the line in getting a grant from the US government and compared that to a group that had just missed out on a grant (one that just made it, one that just missed out).

Ten years later, the group that had not received the grant went onto have more successful careers than the team that had won the government grant.

So those who’d experienced some pain early on in their careers went onto come back stronger than those who didn’t fail.

I couldn’t help but think of how that pain would’ve fuelled their success in later years and how that so encapsulates what I’ve seen in over ten years of trading and watching hundreds of thousands of traders.

Why early successes in trading could hurt you

You may have seen my thoughts on Overconfidence bias before and it got me thinking how much this could spill over into early successes trading.

I’ve seen this far too many times in traders before.

It’s like the story of the tortoise and the hare. It’s the slow and steady trader that wins the race.

The traders I’ve seen who are new to trading will open their accounts, ignore basic risk management and trade gigantic positions on their account and make huge profits on their first few trades. While I love to see it, often they lull themselves into unbelievable amounts of overconfidence and a feeling of invincibility.

They’re the stories you read like “one man makes $1,000,000 trading options on first trade” or “this is how much you would’ve made investing $1 in Google shares since 2004” or “my friend just made $15k betting on AUDUSD” or other financial “junk food” as it should be labelled.  

Because it is too easy in their eyes, they’re always chasing the same early successes they had. 

What I took away from the Nature paper is that the easier we think something is, the more we can fool ourselves into believing something which isn’t true.

Taking the pain

Let me be clear. I’m absolutely not saying that you must lose big to win big. Nor am I saying making money early is bad.  

I’m saying that in my experience, my firm belief (now backed up by some solid research in a different field) is those that suffer early setbacks in their trading are like those who just missed out in their professional lives. In the same vein, if it’s too easy at the start, you can hurt yourself and trick yourself into thinking you’re better than you are.

It’s more like you need to hit some minor lows to hit the highs, but don’t ruin yourself. Call it a bloody nose.

Trading is not some easy game that can be won in the first week or month. Just like you wouldn’t expect to be a pilot after one week of flight training (though you can certainly have the goal!), the same is true for trading.

It’s hard. Very hard. There’s so much to take in and digest. The market is constantly evolving. That’s why you’ll hear statistics like 40% of traders don’t make it. Most people expect too much and give up too soon.

But real success in trading is more like a way of life.

It involves hard work, true grit, hours upon hours of learning and the ability to look and feel wrong many, many times (and often in painful ways both mentally, financially etc).

If you are just starting and you’re shooting the light outs, then maybe that’s not such a good thing. And if you’re struggling, know that you’re not alone.

Far better for you to see it as the challenge that it is. That a little pain is part of the journey and that if it were so easy, everyone would be doing it.

Part II – Hidden Biases in your trading

In Part One, we covered Confirmation bias, recency bias, the endowment effect, the groupthink bias and the gambler’s fallacy.

Today we’ll cover our final five, and I’ll provide you with a handy checklist so you can take 60 seconds and potentially stop yourself from rushing into something catastrophic.

6)    Hindsight bias

You could also call this one the “I knew it all along” effect. How many times have you heard someone say those words in life (not to mention in trading)?

I just knew Euro would fall after the ECB meeting.

Argh, I meant to go long on gold but didn’t get time. I knew it was going up.

We tend to believe that (of course much later than the event itself) that the onset of a past event was entirely predictable and obvious, whereas during the event we were not able to predict it.

Due to another bias (which we will not cover today) called “narrative bias” we tend to want to assign a narrative or a “story” to an event that allows us to believe that events are predictable and that we can somewhat predict or control the future. It allows us to try to make sense of the world around us.

How to overcome: Just stop pretending like you knew what was going to happen. If you didn’t put skin in the game, then you didn’t think it was going to happen!

7)    Overconfidence effect

Overconfidence as a trader allows us to believe that we are superior in our trading, which ultimately leads to hubris and poor decision making.

Whether it’s overconfidence on when to trade, what to trade (telling ourselves “sure I could normally trade AUDUSD, but why couldn’t I also be good at trading the South African rand?”) and how to trade a certain product.

We trade larger than we should, hold losers for longer than we should, relax our own risk management policy, become arrogant or complacent in our trading and this all leads to capital losses.

How to overcome: Ask yourself “What could I be wrong about” or “What makes me think I am far superior to all the others out there with this information”? The market will humble you eventually of course, but why not try to do it yourself before you shoot yourself in the foot?

8)    Anchoring

The first bit of information we hear is what we focus on.

If you ever need to negotiate with someone, you’ll be amazed at the power of anchoring with your first offer (Do try it sometime, just not with your friendly forex broker though ;-))

The same applies to trading. We hear a talking head on TV telling us about how the euro is overvalued and is heading for some drastic number that is streets away from today’s price. We can’t get that number out of our head even if we try.

Or let’s say we buy AUDUSD at .7100, close it at .7300 for a decent profit, happy days! The next week, it’s back at .7100 and we immediately are tempted to do the same again, because why not? It’s cheap again and we can repeat history. We rush into it, ignoring the technical break it’s just had or the negative sentiment on Australian Economic Data. We practically feel it’s a bargain at those levels.  

What do we do? The worst part is that we’re usually not even aware of how strong the influence is.

That’s the power of the anchor. We become attached to that information.  

How to overcome: This one is tough to overcome because studies show it can be so hidden in our subconscious without us knowing. Perhaps add to your trading checklist “Was this trade a result of an unknown anchor that I saw or heard?”

9) Consistency Bias

Like the sunk cost fallacy, we want to be consistent in our actions.

We’d hate for someone to say to us that we weren’t being fair or that last week we had said we’d do X and now had changed our minds.

Politicians do it all the time as they rigidly stick to a poor policy idea. They’d rather go down with the ship.

Traders are worse because our own desire to be consistent costs us money.

If I am known as a USD bear, and it’s rallying hard – I don’t want to look stupid or inconsistent. That’s why I keep staying bearish despite being 1000 pips from being right! It’ll come back we say. Everyone else is being stupid.

In 2009, 2010, 2011 and probably countless years since the financial crisis, people were always calling for the “double-dip” recession. I fell for it myself personally by believing them in 2009 and 2010 and staying too cautious when I should’ve thrown the house at buying stocks!

We want to feel in control. We want people to see our conviction, even if we’re wrong. Because this is a byproduct of confirmation bias, we’re not likely to seek disconfirming evidence of what we believe. We see what we want to see.

Why? Because sadly consistency is often associated with our intellectual and personal strength. Good traders should be seen as flexible. Open to the idea that they are probably wrong. Yet society thinks an inconsistent person is flaky, confused or a ‘flip-flopper’ on issues – even though we could all benefit from being open-minded to new ideas and opinions!

10) The Halo Effect

Last but not least - The halo effect is the final bias we’ll talk about today.

The halo effect means we let our overall impression of someone influence our thinking too greatly.

“But he’s so smart we say”

We idolise the opinions of the legendary hedge fund manager, Ray Dalio or the great investor of our time, Warren Buffet.

We see them on TV or in a Bloomberg article saying now is a buying opportunity or that it’s risk-off and we need to sell.

“If Buffet/Dalio/ is buying/selling now, I’ve gotta too,” we say in our head.

But how smart is that a strategy, really? What might he know that I don’t? What are his investment objectives versus mine? More important – how many times has he said this and actually been wrong?

We don’t know and we shouldn’t try to know. The halo effect blinds to sticking to our own plan and staying in our lane. The more we’re influenced by others, the harder trading becomes.

How to overcome: We must take the opinions of the so-called “Masters of the universe” with a grain of salt. They have different plans than we do. Information that we do or don’t have and so much more. Just because they’ve said this doesn’t make it come true. If only trading were that easy!

What do I do now?

OK, so I might have scared you. You are now jumping at shadows and questioning your own trading decisions, believing you have all these secret, hidden disadvantages that you didn’t have until 10 minutes ago.

Do not worry, biases can never be completely avoided. But we can work hard on challenging our opinions in order to make us more successful. Sometimes it’s just taking the time to stop and think.

To help you along the way, we’ve created a possible checklist for making better decisions in your trading.

So, stop, take a breath and ask yourself these 7 questions before you place your next trade.

What’s the rationale for taking this trade? List 3 for and 3 against.

How strong is the evidence behind my decision to trade?

What are the possible unknown unknowns?

Has the recency of information I’ve learned influenced my decision? If so, how much?

 Is this trade following the consensus of the crowd? If so, is that a good thing?

Did I hear this from a famous market commentator/investor? Why is that important?

 If none of questions 1-6 apply, then could any of the other biases above be at work?

Your first reaction as you read the subject was thinking: “Yeah, but I’m not biased”

Of course, that’s what you would say!

The biggest problem with biases is that we never think we have any.

Biases are what everyone else has.

What are they and why are they important?

Biases are like shortcuts for your brain. They can have an unusually large impact on how you make decisions in your everyday life, but particularly when it comes to your trading.

To put it simply, your brain has a way of conserving energy by making fast decisions or mental shortcuts in what is known as ‘heuristics’.

The problem is, we often don’t even know that we have them. Even if we know about them, when it comes to trading, we must work hard to challenge our reasoning behind making our decisions.

As common as these biases are, we specifically want to focus on what is called “cognitive” and “emotional” biases.

Because these are so crucial to your trading, we’ve split this guide in two. This is part one.
Biases have been studied across psychology, economics and now into the mainstream of what is called “behavioural” finance. In fact, Richard Thaler, a notable behavioural economist recently won the Nobel prize for his work on the topic!

The sad part is that I know more about this topic because of my own mistakes in trading and so I try to be hyper-aware of rushing into trading decisions without considering the biases below.

The million-dollar question becomes, how many of these have you been a victim of and what can you do to try to prevent them yourself?
 
1)     Confirmation bias

This one is a doozy and for me, the most important of all of them.

If you take nothing else from today, it should be an awareness of confirmation bias.

Confirmation bias means we tend to seek out information only that we agree with.

Ask yourself this question: How many times have you placed a trade then sat there and watched it go against you? Sure, this happens almost every time, but then how often have you then gone out and sought information, headlines or “expert” advice about that currency pair which tells you why you were right and to just stick with it?

I remember many years ago, when I first started trading, I placed a fairly large trade on oil (don’t ask why I made this trade. I had no idea what I was doing and it was too big for my account... Forgive me, I was just a beginner!) but as soon as it went against me I frantically typed “Oil” into Google, and just like that I was looking for any reason to support my original opinion on why oil was due to go through the roof.

To my joy, there was some analyst from ABC Fund manager comforting me with a view that supported my own opinion or perspective. They talked about an undersupply in the market and that oil was sure to go higher. It was 2 am and I was sitting in my lounge room by this stage as I watched my whole account go into jeopardy. This valuable advice that I sought helped to nurse me back to sleep.

I, of course, deviously chose not to click on any article that might tell me I was wrong – I only sought out the information I wanted to hear or see.

Let’s just say that the oil trade I placed went as well as a parachute made of concrete! (Oh and my account was completely wiped out!).

How to overcome it: Stop, ask yourself a question – What information could you be missing about the rationale for this trade? What do the opposing arguments and research say?

2)    Recency bias aka availability heuristic

The “recency bias” or “recency effect” essentially tells us that our recent experience can become the baseline for what is going to happen in the future.

This might mean our recent trade performance such as a recent win or loss impacting us heavily. It might also mean a certain piece of news or information that we recently heard forming the basis for our decision making.

This can have seriously dangerous consequences for us as traders as it undermines our ability to form an objective decision on a trade. Why? Because of our lazy brain only recalling recent information. Whether that’s on our most recent trade or information we found as a barometer for how the next trade will go.

Let’s say you had a losing trade whereby you promised you’d never risk such a great amount of your capital again. You might be a little shy and dial back the risk a bit too much, or you could be the opposite and think you’re George Soros, betting the whole house on the next trade since you just went so poorly on the last. Your thinking is this would get you back to where you were prior to your last trade.

The other way it can creep into your trading is through recent information impacting your decision on why to take a new trade. It might be that you see a brief news headline stating ABC bank’s research on “why the dollar is going to dive this week” earlier in the day and tend to argue with yourself later that night why you think it’s a good idea to follow that trade. I know what you might be thinking: “It’s just a headline… I’d never let this happen to me”. However, our brain likes to take shortcuts to conserve energy. It will do its best to take what it knows and ignores the rest (as we have learned above).

We also have a tendency of the fear of missing out (FOMO as it’s popularly known today) and with this new information, we feel we must put something into action!

How to overcome the bias: As difficult as it may be, you must stop, count to three and ask yourself a few questions.

These could be “why am I making this trade?”, “Does it fit in with what I know?”, “What am I missing here?”, “Have I read something recently about this?”. Better yet, build yourself a checklist with these questions on it!

3)     The Endowment effect / Sunk cost fallacy

The endowment effect means we tend to value something more after we’ve owned it for a while.
In a now-classic study featuring Richard Thaler and Daniel Kahneman (both Nobel prize winners), students were given a mug and were asked how much they would sell it for an equally valued pen as an alternative. The experimenters found that the median price for which they would sell was TWICE as much as they were willing to pay to acquire the mug.

Because of our aversion to losses (also known as prospect theory – another big bias which I’ll cover later), this can have a drastic effect on our trading success. We place a trade on AUDUSD, with a target profit or loss of only 50 pips. Yet when the trade starts to go against us, what’s the first thing we often do? Move our stop loss further out because we “just know it’s going to turn around.” We tell ourselves stories like “The euro is cheap here, it’ll definitely turn around.”

Because we are committed to this trade (and this is somewhat related to the confirmation bias) we value it more just because we own it and because we have already invested in it, it becomes a “sunk cost”.

How to overcome: Fairly obvious advice to start; keep your stop losses and targets where they are. Be more mindful about why you’ve put them at these levels. If it helps you, write down the reasons why you’ve placed your stop and profit there and you can take comfort in understanding your own reasoning.

4) “The Gambler’s fallacy”

The gambler’s fallacy is where we believe that future probabilities are altered by previous events, when in fact, they’re unchanged.

It is called the “gamblers fallacy” due to the often-watched scene of any table game at the casino (e.g. roulette) as it continues landing on black over and over. People see this and think ‘it couldn’t possibly do that again’ and try to bet against it.

Being contrarian is great, don’t get me wrong.

However, as traders and human beings, we tend to believe that if something happens multiple times, it couldn’t happen again. We ignore simple probability.

Let’s say the S&P500 has rallied five days in a row. We place a trade in the belief that “it must be due for a correction” only to watch it rally and stop us out of our position.

How to overcome: It is important to look at the original thinking that led you to this trade. Just because something has moved up or down in a continuous fashion, it does not mean the market will immediately reverse its behaviour and go the other way. Just try catching a falling knife and you’ll know why.

5)     The Groupthink Bias

The “groupthink bias” is our inclination to do or believe things just because others do the same. Also known as the “bandwagon” or “herd behaviour”, it can lead to having a serious trading hangover; ask yourself an odd question like “why on earth did I go long the EURCHF last night?”

After all, you can’t do the same things others do and expect to win.

A recent example was after the US Presidential election. Everyone thought if The Donald got in, it would be a huge negative for the markets and the economy. Stocks fell initially and hard.

If you cashed out then and there because you thought it was going to lead to Armageddon, you made a very expensive mistake!

How to overcome: Sometimes it pays to be contrarian. If everyone is saying it’s going up, consider if going the same way will lead to riches. If everyone is saying it’s going down the toilet, consider if they could be wrong.

Be careful of those bandwagons!

So, which of the above are you most guilty of?