For all the data and analytics in the world, investors are usually driven by psychological factors. These factors may range from fundamental elements such as economic stability to purely subjective factors like expectations.
As such, psychological levels are generally associated with resistance and support levels. For instance, investors may set up a round number as a particular threshold that must be crossed in order for them to buy or sell.
Consider this situation:
A currency pair has been trading in a predictable Bollinger Band. The price fluctuates from a high of 1.48 to a low of 1.41. As such, investors may not feel compelled to act out given the fact that there are very few incentives to make any large moves. This is due to the fact that investors see the 1.50 mark as a threshold. If the price moves past this point, they will sell. This would then trigger a flood of sell orders and knock the price back down. In contrast, investors will begin dumping their positions if the price falls through the 1.40 mark.
It should be noted that there may be no technical reasoning for this psychological expectation. However, investors have seen these round numbers, 1.40 and 1.50, as milestones that will dictate their ultimate reactions. This is why technical analysis should become your new best friend. Without it, you are left with subjective assessments that may have no real foundation for them. As a result, you might not make the best investment decisions. However, if your psychological perception is based on technical data, then you have a very good chance of making sound investment decisions and subjective assessments based on hard data.
Risk Management in Divergence Trading
Risk is an investor’s worst enemy. Simply put, the greater the risk, the greater the chance you will lose money. This is why managing risk is so important when it comes to successful trading. On the whole, you can manage risk by paying close attention to the data. The more you study the data, the easier it will become for you to spot trends simply by looking at charts. Often, these charts will tell you everything you need to know. You won’t even have to consult any expert advice. The combination of data, experience, and instinct will be enough to guide you.
That being said, here are some useful tips to keep in mind when managing risk.
- First, avoid committing too much in a single trade. Even if the trade setup looks perfect, it’s always best to avoid committing too much money in one trade. The level of risk skyrockets the more money you put into a single trade. So, keeping the 1% to 2% rule in mind will save you from making a terrible mistake. This is especially important when you are first starting out.
- Second, avoid making deals based on false signals. Always look for all of the signs before entering a trade. If there is a signal missing or if you are unsure, then don’t enter the trade. It’s better to see you missed out on an opportunity rather than regret getting in. There will always be another opportunity.
- Third, play it safe. It is always best to err on the side of caution. If you find that the setup is perfect, committing 2% of your investment capital will be more than enough to validate your thoughts.
- Lastly, diversification is key. Most successful investors have multiple positions open in various currency pairs. This allows you to manage risk more effectively as you are not dependent on the action of a single currency. When you spread risk out among various currencies, you reduce the likelihood of missing out greatly. So, do your best to enter multiple positions in various pairs. That way, the losses from one deal can be offset by the winnings of another.
On the whole, risk management boils down to using common sense. When you follow the data and use your good judgment, you will find that missing out on a deal would be tough. You won’t miss out on any good deals. Rather, you’ll stay on the right side of your mistakes. While you will not have a perfect streak, the likelihood of you getting wiped out will be far less. That is why keeping the various guidelines provided in this chapter will ensure that you will come out on top more often than not.