Published On: Tue, Jan 29th, 2013

Reducing risk when using fundamental analysis

If you have already designed or attained a trading strategy then you would appreciate that adhering to its concepts for any length of time is difficult especially if you have not developed a powerful trading mindset. For example, many investors experience significant drops in their morale and confidence after they suffer sequences of consecutive losses causing them to abandon their strategies. This is one of the primary reasons why you must expend your time and resources in order to perfect your trading psychology so that you can produce quality decisions with consistency and discipline,

If your dream is to acquire substantial profits from your trading, then you will need to apply and implement your trading strategy consistently and accurately for an extended period of time. Expert consensus instructs that this objective can be best accomplished by learning how to activate trading opportunities using a well-tested set of rules that you can instigate with confidence and discipline. In addition, they strongly advise that this approach must include the concepts of a well-proven money management strategy and then applied with a professional trading psychology.

For example, you must use your strategy to protect yourself from the demoralizing effects of events such as a string of losses. If you fail to initiate such safeguards, then your natural reaction, which will be to avoid any additional stress generated by further losses, will cause your belief in your strategy to wane substantially. You will then find that your trading decisions will be plagued by increasing levels of fears, doubts and anxiety should you allow this to happen.

You must understand that a trading psychology is influenced by many human emotions. For instance, you may endure intense frustrations if your live trading results do not match your prior hopes and expectations. Alternatively, you may experience escalating levels of anxiety if you lose total confidence in your trading strategy after suffering disheartening and demoralizing experiences when trading the financial markets. For example, how can you maintain a positive trading attitude and posture if you have just suffered a painful series of very serious and distressing losses?

One important fact about trading the financial markets is that you will always experience losses no matter what you do. This is why experts emphatically advise that one of the central specifications of any strategy that you deploy, must be to safeguard your trading psychology from the debilitating effects of failure.

You must also learn how to cope with trading difficulties such as the following. Consider that you suffer a loss equating to 50% of your entire equity on a single trade. Consequently, you would then be in an appalling position whereby you would need a win of 100% just to regain your initial account balance. This serious problem is called a drawdown and as it can have a devastating impact on your account balance and morale; it must be avoided at all costs.

You must especially take steps to counter drawdowns when you are trading the financial markets using fundamental analysis. This is because events can be generated that are capable of unleashing high levels of volatility creating large erratic price surges. For example, the publication of very important economic data is notorious for producing such patterns as illustrated in the following diagram.

fundamental risk

The above chart demonstrates the intense impact that a recent release of the US non-farm payroll data had on the EUR/USD currency pair. A better-than-expected value initially produced a bearish price spike in the EUR/USD. However, this movement was rapidly reversed shortly afterwards. Price surges, as illustrated above, frequently occur after major fundamental information is posted. Consequently, you must be vigilant under such conditions to prevent you positions from being stopped-out and preserving your account balance from drawbacks.

This is why you must strive to steel your trading psychology from the dramas of such fundamental events. You can do so by first focusing on the size of your potential losses as opposed to becoming obsessed with the large profits that such events present. You must be able to analyze these trading conditions objectively without allowing your emotions, such as greed, to interfere with this process whatsoever. Unless you can attain the mindset of an expert, you will just subject your equity to extremely high levels of risk.

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About the Author

- Marcus Holland has been trading the financial markets since 2007 with a particular focus on soft commodities. He graduated in 2004 from the University of Plymouth with a BA (Hons) in Business and Finance.