Forex Trading Rules: Logic Wins; Impulse Kills
More money has been lost by trading impulsively than by any other means. Ask a novice why he went long on a currency pair and you will frequently hear the answer, "Because it has gone down enough - so it's bound to bounce back." We always roll our eyes at that type of response because it is not based on reason - it's nothing more than wishful thinking.
We never cease to be amazed how hard-boiled, highly intelligent, ruthless businesspeople behave in Las Vegas. Men and women who would never pay even one dollar more than the negotiated price for any product in their business will think nothing of losing $10,000 in 10 minutes on a roulette wheel. The glitz, the noise of the pits and the excitement of the crowd turn these sober, rational businesspeople into wild-eyed gamblers. The currency market, with its round-the-clock flashing quotes, constant stream of news and the most liberal leverage in the financial world tends to have the same impact on novice traders.
Trading Impulsively Is Simply Gambling
It can be a huge rush when a trader is on a winning streak, but just one bad loss can make the same trader give all of the profits and trading capital back to the market. Just like every Vegas story ends in heartbreak, so does every tale of impulse trading. In trading, logic wins and impulse kills. The reason why this maxim is true isn't because logical trading is always more precise than impulsive trading. In fact, the opposite is frequently the case. Impulsive traders can go on stunningly accurate winning streaks, while traders using logical setups can be mired in a string of losses. Reason always trumps impulse because logically focused traders will know how to limit their losses, while impulsive traders are never more than one trade away from total bankruptcy. Let's take a look at how each trader may operate in the market. (To get a better understanding of traders, check out Understanding Investor Behavior.)
The Impulsive Trader
Trader A is an impulsive trader. He "feels" price action and responds accordingly. Now imagine that prices in the EUR/USD move sharply higher. The impulsive trader "feels" that he has gone too far and decides to short the pair. The pair rallies higher and the trader is convinced, now more than ever, that it is overbought and sells more EUR/USD, building onto the current short position. Prices stall, but do not retrace. The impulsive trader, who is certain that they are very near the top, decides to triple up his position and watches in horror as the pair spikes higher, forcing a margin call on his account. A few hours later, the EUR/USD does top out and collapses, causing Trader A to pound his fists in fury as he watches the pair sell off without him. He was right on the direction but picked a top impulsively, not logically.
On the other hand, Trader B uses both technical and fundamental analysis to calibrate his risk and time his entries. He also thinks that the EUR/USD is overvalued, but instead of prematurely picking a turn at will, he waits patiently for a clear technical signal - like a red candle on an upper Bollinger Band® or a move in the relative strength index (RSI) below the 70 level - before he initiates the trade. Furthermore, Trader B uses the swing high of the move as his logical stop to precisely quantify his risk. He is also smart enough to size his position so that he does not lose more than 2% of his account should the trade fail. Even if he is wrong like Trader A, the logical, Trader B's methodical approach preserves his capital, so that he may trade another day, while the reckless, impulsive actions of Trader A lead to a margin call liquidation. (To read more on technical and fundamental analysis, see Technical Analysis: Fundamental Vs. Technical Analysis.)
The point is that trends in the FX market can last for a very long time, so even though picking the very top may bring bragging rights, the risk of being premature may outweigh the warm feeling that comes with gloating. Instead, there is nothing wrong with waiting for a reversal signal to reveal itself first before initiating the trade. You may have missed the very top, but profiting from up to 80% of the move is good enough in our book. Although many novice traders may find impulsive trading to be far more exciting, seasoned pros know that logical trading is what puts bread on the table.
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