Your Mind Works Against You

Interestingly enough, your subconscious agrees with Fido whenever you trade…

Let me explain.

Everyone who has been trading Forex for a while knows the golden rule: to cut your losses short and let your profits run.  But with a quick review of a typical retail Forex trader’s account, you will probably find tons of small profits followed by huge losses…

Sometimes the losses are so big they wipe out weeks of profit or even a good portion of the starting balance…   This problem is not only isolated to novice traders because if you’ve been following the news lately, but you’ve also heard of scandals of billions of dollars of losses from some of the most prominent financial institutions’ “foreign exchange trading desk”… 

Positive and Negative Framing

To understand this problem that every trader faces fully, we must understand human nature, and examples of Positive and Negative framing best illustrate it…

Let’s say that you are guaranteed to win $4000 right now, and you are given a chance to win $1000 more ($5,000 total) with 80% of odds of winning.  If you win, you will go home with $5000, but if you lose, you’ll end up with nothing, not even the $4000 you started with.  So the choice is yours, take $4000 now or take a chance at $5000 with a 20% possibility of leaving with nothing. What would you do?

80% of people will choose the $4000, not the gambling scenario.  But let’s change the situation around and see what you’d do:

You are guaranteed a loss of $4000 right now, and you are given a chance to lose more (80% probability) and end up with a $5000 loss, but there is a 20% chance you will come out breaking even or not losing anything.  The choice is the same as the previous example, but the situation is reversed…  $4000 loss right now or a $5000 possible loss in the gambling scenario with a small chance of breaking even. What would you choose now?

Interestingly, 80% of people would choose the gambling scenario, even though both examples are the same.  If this question was posed to a computer or Artificial Intelligence, we should get the same answer because 80% odds in the gambling scenario makes it the right choice in Example 1 and the wrong choice in Example 2.  But strangely,  80% of us normal Forex traders will always choose the WRONG answer every time.

Losing outweighs winning

It all comes down to this one thing: the pain of losing outweighs the pleasure of winning.  If you find a $20 bill on the ground, you’d probably not frame it on the wall, but you’d spend it without thinking twice.  But if Bob owes you $20, you’d probably remember that forever, and that’s human nature… 

So when it comes to trading, one’d rather take the gambling scenario and let the losses run because there is that fairy tale kind of chance for the market to turn around or to delay the pain of losing… but more often than not, you’ll end up losing more…

Understanding your mindset is important, and the next time you think about the gambling scenario, do yourself a favor and cut your losses short because it only takes one huge loss to undo what you’ve worked for so long…