What is an emotion management system for traders?

Managing traders' emotions

Your emotion management system is the subsystem of your trading plan, which determines how you follow your trading strategy and risk management system. Control is achieved by reducing destructive emotions (those that force you to deviate from your strategy) and enhancing beneficial emotions (those that force you to stick to your strategy). When you achieve control, emotions that cause you to deviate from a trading plan are prevented, and the emotions that encourage full adherence are instead enhanced.

The principle of the emotion management is that each type of emotion uses part of a limited stock of mental energy which must be carefully protected from waste. An emotion is, in essence, a form of mental leverage that transforms ideas into actions. As this stock of mental energy tends to be limited, it should be used with care - without getting too attached to your trades (in the same way that leverage is used sparingly), so that no trade can harm you emotionally, as the outcome of a trade is almost always random. It is better to use this energy to set up your trading plan rather than building your subconscious fears (which are often inappropriate defense mechanisms derived from your past experiences). Below is a description of destructive and beneficial emotions along with the techniques that can be used to deal with them.

As the great Charles Faulkner once said: "Managing one's emotional state is key. Truly exceptional traders can stand up to anything. Instead of getting emotional when things aren't going the way they want, they stay calm and stick to their strategy plan".

Destructive emotions

One of the strongest destructive emotions is the fear of losing money. This fear stems from internal mental programming that will lead you to believe that money is a limited, highly important commodity. Most people have come to associate money with various types of goods (cars, jewelry, etc.) and intangibles (such as safety, personal value, prestige, etc.). Due to this unfortunate process of association, money comes to symbolise both freedom and prosperity. The association is so strong that any "attack" on the capital base (such as a series of losing trades or a large price move against an open trade) is likely to trigger defensive mechanisms in the form of fear to protect one's notions of well-being. This fear can lead to the premature close of a profitable position - that is, before the exit signal is generated by the trading system being used. This fear may also lead you to not take a signal after a series of losing trades or to open a position that is smaller than the size suggested by your risk management system.

The twin brother of fear is the greed that comes from the same mental programming towards money. Greed can manifest itself by making a trader hold a position longer than his or her trading system dictates - that is, beyond the time the exit signal is generated. Greed can cause a trader to open a position when there is no signal to enter (you can also say this is fear - the fear of missing out on a trading opportunity). It can also cause a trader to dramatically increase his or her position size after a long series of winning trades - in direct violation of the parameters set by the trader's risk management system.

To overcome fear and greed, just remember that your goal isn't to seize every single trading opportunity. It would be extremely dangerous to try to take advantage of every profit opportunity that presents itself - as no system or trader can consistently identify them all. Your goal shouldn't be a quick profit - it should be consistent performance and the confidence that you'll achieve your profit goal if you stick to your system. Your backtesting will also show you that as long as you follow every signal from your trading system and every instruction from your risk management plan, you'll eventually reach your profit target.

Even the best trading systems can go through long losing streaks. If you model a few trading scenarios, you'll notice that systems with positive mathematical expectations tend to become profitable in the long run (after a few dozen trades), although they may experience a few short-term losing periods. It is therefore useful to refer to your risk management system to define the sizes of your positions.

As trader John R. Hill says: "A trader's psychology can make or break a trading plan. One of the benefits of a trading system is that it eliminates human emotions. When a trader overrides a trading system, he loses this edge. How many traders follow a trading system after a series of 6 losses? To reap the benefits of a trading system, all traders should take the 7th trade".

If you trade with a mechanical trading system, you can solve all the problems created by your emotions by simply automating the trading process. However, if you are using a discretionary trading system, where your mind generates trade entry and trade exit points, conflict is likely to arise when your trading system and your mind want opposite courses of action. It is likely, though, that your emotions will outweigh your trading signals in a very stressful situation. This is especially true for new traders with limited experience. The mental system they have built (often relying on advice they found on the internet) is still unsophisticated compared to "older", more powerful money-related defensive systems they have established over the years. For this reason, the only way for you to learn discipline early in your trading career is to follow a professional forex trading system. Otherwise, you simply won't have enough confidence in the system with which you can combat improductive and destructive emotions.

Another renowned trader, Ralph Vince, says: "As with many other traders, I'm often my own worst enemy. This is true not only in my activities in and around the markets, but also in life in general. Other traders don't pose the same threat to me as I do. I don't think I'm the only one in this situation."

Beneficial emotions

Confidence in your risk management and trading strategies is the first emotion necessary for success. It's also important because it forces you to follow your systems. When you are confident, proper execution is bound to follow (trade execution accuracy is directly proportional to the degree of trust you have in your trading system). It is therefore very important to cultivate this feeling as much as possible before you start trading. If you don't have enough trust in your system, it will invariably lead to deviations from them - with harmful consequences for both your self-esteem and your trading account. Every signal that you ignore or skip reduces your trust in your trading system. Ultimately, trading discipline can be defined as [(trust in your method) / (signals not taken)]. The more signals you miss (intentionally or inadvertently), the more impact it will have on your trust in the system and the faster your execution will deteriorate, leading to a further downward spiral. Your trading success can only occur when you take into account each one of the signals your system generates, whether it is a mechanical signal or your own intuition (if you are using a discretionary trading system). By closely following your trading system, you are actually strengthening your own discipline, which will help you stick to your system during difficult times (losing streaks).

Trader Tony Plummer famously said: "The only thing that matters in the end is that the forex trader is sufficiently confident in the signals that he won't continually question each trade or exit he makes."

To maintain your trust in a system, you need to have experience trading with it. As long as the system continues to work the same as in the past (without significant deviations), you can fully trust it. It helps to remember that there is absolutely no certainty in forex trading and that the only way to reach your profit target is to come up with a realistic idea of ​​your system's future performance. You should carefully consider measures of system performance (from backtesting, for example) such as average trade length, average profit/loss, maximum drawdown, longest wining/losing streak, etc. before you start trading with real money. Knowing these statistics will help bridge the gap between expected and actual system performance and, therefore, reduce stress and enable you to maintain your trust in the system during the inevitable drawdowns. Some experts also say that you should intentionally lower your expectations, however, you should only do this if you don't have enough real-time system performance data (the system is mainly evaluated on the basis of retrospective data).

As trader Tushar Chande said: "To change your emotional expectations, you can use the following "rule of two": 1. Expect your test to get you half the number of winning trades in a row you expect. 2. Expect twice as many losing trades in a row as your test might show. 3. Prepare for half the expected profits."

Another important condition is that you stick to the method you have chosen. If you don't stick to just one method, you will most likely waste your energy and capital between several methods, abandonning each one at the slightest sign of an imperfection. In fact, there is no such thing as a perfect "holy-grail" trading system. All trading systems will experience their own losing streaks. You cannot escape it. It is best to accept this truth before you start trading, so that there are no unrealistic expectations that can jeopardise your commitment when trading with real funds. To strengthen your commitment to a trading approach, you need to reduce your emotional involvement in every trade. In other words, you need to treat both wins and losses with the same emotional detachment. Trading the forex is a game of probabilities: as long as you stick to a proven method, you will reach your profit target over time, regardless of the specifics of your individual trades (which can almost never be predicted in advance).

John Percival famously said: "If you are serious about winning, you can make a billion dollars or multiply your current holdings by 100 - over time."

And as Ryan Jones says: "The only traders that fail are those who give up".

Traders' emotion management methods

You can manage your emotions by reprogramming your subconscious mind in order to channel your mental energy into productive behaviour, such as sticking to your trading strategy. The first and most important step is to learn to feel emotions only in relation to your trading actions, not the price you see on the screen. It doesn't matter what the price is doing now (for example hitting new lows or highs). Once you've received a signal from your system, you can set up the trade right away. Also, keep in mind that it's much more useful to regret a missed signals than it is to mourn a missed opportunity not detected by your system. Indeed, no opportunity for profit can be compared to the possibility of long-term geometric capital growth made possible by the consistent use of your trading strategy.

The method of shifting your focus and emotions from one aspect of trading to another in order to profit rather than suffer from your emotions has given rise to a new approach. The following list includes the changes described above along with a few more useful ones:

  1. Shifting from actions based on price to those based on your strategy's signals.
  2. Shifting from a missed opportunity not detected by your system to the long-term geometric capital growth made possible by closely following your trading method.
  3. Shifting your attention from profits to losses.
  4. Shifting your attention from a single loss to a series of losses (drawdown).
  5. Shifting your creativity from real-time trading (reducing emotional attachment to a single trade) to creativity in your trading system's development phase.
  6. Shifting from a euro/pound/dollar value of your profits/losses (and the material rewards you can buy with that money) to their value as a percentage of your account balance.

It should be noted that the destructive emotions mentioned above can actually be turned around in a productive manner. Rather than worrying about losing money on a single trade, you can condition yourself to instead worry about missing a trading signal, which would hamper the geometric capital growth process. It is better to wish for geometric capital growth rather than an accidental profit not initiated by your system. Rather than opening a trade when your system gives no signal - because of a momentary creative impulse - it is better to feel the pride of your knowledge and experience embodied in your trading system by sticking to your system.

You can make affirmations of the above changes and repeat them daily to yourself to imbed them into your subconscious. For example, "I will shift my focus from the currency's price action to the way I follow my trading system." By internalising these principles, they will become your silent "guardian angels", who will protect you from any harmful effects that you would otherwise encounter.

Trader Tony Plummer says: "The affirmation is to be made to yourself regularly, out loud if possible. So for example, the basic statement "Every day I trade according to the rules of my trading system" can be a powerful reinforcement of your goal".

Plus, if you think of your capital as your "trading career", all of the basics of trading will come naturally to you. Since one's instinct for self-preservation is a very powerful emotion, if you are able to condition it to accept that your capital represents your trading career, you can be sure that it won't allow you to take excessive risks (i.e. greater than those defined by your risk management system) and will force you to only use signals from your system. Only this will help you achieve your goals in a consistent manner.

Here is another principle that can be useful for removing emotions from your trading:


Retaining control of your emotions

To control your emotions, you must remember that any forex trading system is, in essence, an organised method of taking advantage of other traders' emotions - therefore, unless you learn to control your own emotions, you won't be able to take advantage of any system. The path to complete mastery of one's emotions is very long and requires a lot of self-questioning. This is why novice traders are encouraged to automate their trading systems - which can sometimes save them lots of time. It should be noted that the advantages of automating mechanical trading systems far outweigh, in most cases, the relative advantages of the human mind's superior abilities to recognise chart patterns - precisely because the human mind (or rather its logical part that identifies patterns) doesn't work in a vacuum, but alongside other subconscious mental frameworks that often hamper the decision-making process with destructive emotions.

If you nevertheless decide to manually run your forex trading system, you can still learn to manage your emotions (i.e. remove the mental blocks that prevent you from successfully doing so).

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