THREE CRITICAL SUCCESS FACTORS

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THREE CRITICAL SUCCESS FACTORS

Postby SharpForex » Sun Jul 31, 2011 4:53 am

Before you dive headfirst into Forex trading there are three critical success factors that you will need to study and understand. These factors are listed below in order of importance:

1. Trading Psychology;
2. Money Management; and
3. Market Analysis.

Now, I am not a gambling man, but I bet you thought Market Analysis would be the number one critical success factor. After all, if you get this part right the rest will just fall into place, right? Concepts like Trading Psychology and Money Management are of secondary importance and would surely come much farther down the list of priorities?

So let’s put this theory to the test. You have analysed the GBPUSD currency pair, and all indications point towards a buy position, but you are hesitant? Where is this fear and uncertainty coming from? Your analysis say’s “buy” so go ahead and buy…what’s stopping you? Is it fear of your analysis being wrong and making a loss?

After much deliberation you place the buy order and you are long the GBPUSD currency pair. Immediately price action moves in your favour and you are showing a small, but promising profit. Price action continues to move in your favour and your profit continues to climb, but then, without warning, prices begin to decline. Your indicators show that the trend is still in play and prices have a long way to go before a peak is reached, but right now prices are retracing and you are watching your profits dwindle. What should you do? What if your analysis is wrong and prices plummet from this point forward? What if you pull out now, but the trend resumes its uptrend and you miss out on windfall profits?

Ah, trading psychology is real, and its impact can debilitate and paralyse your ability to make logical trading decisions right when those decisions are needed the most.

An understanding of trading psychology, and its impact on your ability to make timely decisions, is a critical success factor in trading Forex and all other markets including stocks, futures, options, and commodities. But because we are talking about the mind and the emotions it manifests based on situations that confront us, we are not able to grab hold of it and make it do what we want it to do. No matter how hard we try we cannot prevent the mind from reacting to uncertainty, fear, greed, and elation.

The solution is to control those events that create these emotions in the first place, and thus, eliminating those emotions that debilitate and paralyse our decision making process. We can achieve this by replacing uncertainty with certainty.

Imagine a two horse race with horse number 1 paying 2:1 odds and horse number 2 paying 5:1 odds. Your market analysis may indicate that horse number 1 offers the best chance of a win based on past form, but you only get one shot at this and if you are wrong you lose. But what if you placed a $300 bet on horse number 1 at 2:1 odds, and a $100 bet on horse number 2 at 5:1 odds?
You earn $300 if horse number 1 wins, less $100 for the loss on horse number 2, for a net $200 gain. Alternatively, you earn $500 if horse number 2 wins, less $300 for the loss on horse number 1, for a net $200 gain. I would love to spend a day at this track!

Which has taken priority here, market analysis or money management? And what is the effect on psychology? See how a little bit of money management has cancelled out the psychological negatives and replaced them with psychological positives? The certainty that you cannot lose!

In Forex trading you cannot know the winning odds with certainty, but good money management that keeps track of past performance can be useful. Tracking your past trades to calculate your batting average (winning trades against losing trades), and the average amount won on a winning trade, provides good information for managing future trades.

If your batting average is, say, 50:50 and the average amount won on a winning trade is, say, $50 per trade, then in every 10 trades you will win $250. If you are striving to achieve an average 3:1 risk/reward ratio, you can afford to lose no more than $16.66 per losing trade ($50 / 3 = $16.66). In other words, your stop-loss should be no more than $16.66 in value.

Look at the difference this makes to your GBPUSD trade. You can enter the trade with confidence that if your analysis is wrong you will lose no more than $16.66 on this trade, and if your analysis proves correct you have the potential to earn $50 from this trade. The $50 win is not guaranteed (it could be more or less) but it is the potential based on your trading track record. You know also that if you lose on this trade it is just part of the numbers game applicable to your trading style, and that on average, you will lose on 5 trades and win on 5 trades. It all becomes matter of fact.

Now, assuming you have entered a winning trade, at what point should you exit? Here comes that psychology again, and this time it manifests itself as greed. You want to take profit now to avoid giving some of it back, but you also want to ride this trade further for even greater profits. What should you do?

Let your profits run whilst protecting profits earned. In our GBPUSD example, move your stop-loss to a point that is $16.66 away from the current price. By trailing your stop-loss so that it moves in the direction of your position, but remains fixed during a price retracement, you reduce risk and lock-in profits. Your tailing-stop moves in increments that will close the gap between the entry stop-loss and entry price. When the trailing stop-loss is equal to the entry price you have reached breakeven, and risk is, of course, completely eliminated. As price action moves further in your direction the stop-loss is adjusted accordingly, with the effect of locking-in accrued profits. This occurs when the stop-loss passes the entry price, so that the difference between the stop-loss and entry price represents profit. You cannot lose from this point forward.

Every time there is a price retracement the stop-loss remains fixed in place. If a price retracement fails to trigger the stop-loss, and the previous trend resumes, then the stop-loss will continue to move up with the price action and thus, lock-in further profits. If a price retracement hits the stop-loss the position is closed and profit is taken.

Again, which has taken priority here, market analysis or money management? And what is the effect on psychology?

An understanding of trading psychology and how it affects your ability to make rational trading decisions is paramount. With an understanding we can introduce control measures that remove psychological negatives and replace them with psychological positives, and in so doing, create a matter of fact trading environment that is stress free.

Money management allows us to gain an understanding of our trading style and performance by reviewing and analysing our track record, and using this information to develop a money management strategy. The money management strategy removes doubt and uncertainty, and replaces this with fact and high probability, and thus, disarms negative trading psychology and its potential to harm our trading performance.

So where does this leave market analysis?

Forex trading is a 50:50 proposition. Prices will either rise or fall, and depending on which side of the trade we take, we will either win or lose. Our market analysis helps us determine which side of a trade we should take, but it’s not perfect and sometimes we get it wrong. When we are wrong we lose, and money management is there to control how much we lose. When we are right we win, and money management is there to ensure we maximize our winnings. Money management gives certainty to trading outcomes, which in turn eliminates negative psychological impediments.

Money management is dependent on our market analysis performance, or track record. It uses our batting average and average amount won on a winning trade to calculate risk/reward and stop-loss values. Hence, it is directly tied to market analysis, and the results delivered by this analysis.

Improved market analysis can result in batting average improvements, which will filter through to money management calculations. Likewise, the average amount won per winning trade might improve, thus impacting money management. The link between market analysis and money management is, therefore, of a dynamic and never ending nature. When you think about it, you simply cannot have one without the other.

Whether you use Fundamental Analysis or Technical Analysis to generate buy/sell signals is irrelevant, as are the number and type of analytical tools employed. You will either buy or sell dependent on the results of this analysis, and this will result in either a profit or a loss. Simple as that!

So now we have come full circle.

As keen and eager as we may be to get stuck into market analysis, we now realise the importance of trading psychology and its impact on our trading decisions. If we are in doubt or we hesitate to act in a timely manner we risk missing trading opportunities, or we fail to exit the market and thus keep losses under control. Further, when in profit we agonise over our decision to hold a position or exit a position, and hence, we risk taking profits too soon or giving back a large proportion of those profits. These emotions, the psychology of trading, must be neutralised before we begin our trading, and because these emotions are directly tied to fear of loss, then the task of neutralising them must fall to money management.

These three critical success factors, trading psychology, money management, and market analysis, are directly linked to each other, and your trading success is dependent on maintaining a balance between them.

A trade signal must be backed with certainty. This comes in the form of a clear and precise stop-loss, and in the knowledge that if this trade results in a loss it is just a numbers game and in the long run you win more than you lose. This prevents trading paralysis brought on through doubt and uncertainty.

Money management is key to providing certainty, but is dependent on trade performance feedback to achieve its task. It needs to know batting averages and average amounts won on winning trades to calculate the information you need when entering a trade.

And of course, market analysis performance feedback used in money management can also provide a benchmark against which to improve your market analysis. Modifications and fine adjustments to market analysis methods can be employed, and feedback used to determine if improvements to the batting average or amount won on winning trades has been achieved.

If you are new to trading, or you are seeking to improve your trading performance, then it will pay you well to gain a better understanding of trading psychology and how it impacts on your trading style and trading results. I suggest opening a demo account and keeping notes of when you encounter hesitation, uncertainty, and fear. Prove to yourself the truth in what I have outlined above. You may also want some good reading material to explore the subject of trading psychology in more detail, and for this purpose I can recommend “Trading In The Zone” by Mark Douglas. Google for more information.

If money management provides the necessary tool to satisfy trading psychology factors, then it stands to reason that you ought to spend some time here gaining knowledge. Your demo account is a good starting place because it will allow you to gather data about your trading performance – batting average and average amount won in a winning trade. You also need to gather information about money management to become familiar with concepts like the “2% rule”, calculation and use of stop-loss orders, lot sizing, and risk of ruin. Again, Google and you will find an abundance of information about this topic.

Market analysis. Suddenly this topic finds itself at the bottom of our list of priorities, and that’s because its sole purpose is to help you decide between a buy or sell position. I am not suggesting for one minute that market analysis is of less importance than trading psychology and money management, but rather, I am stressing the point of just how futile good market analysis becomes if you fail to address trading psychology and money management, and if you fail to see the direct relationship between these three critical success factors.

Stress-free and profitable trading to you!

Gary Sharp
SharpForex
 
Posts: 15
Joined: Fri Jan 14, 2011 4:32 am
Location: Melbourne, Australia

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