Updated from its original posting on 2012-03-16
If you listened in class back in grade school when the scientific method was taught, pat yourself on the back! Having this kind of mindset may just give you an edge in the forex market. In case you’ve forgotten what the scientific method is all about, here’s a quick review:
Scientists always start with observation. To put simply, it is the process of using the senses to gather data about consistencies in the environment. Observation allows one to differentiate patterns from random incidents.
Once a scientist has gathered enough data, what follows next is theory-formulation. Humans are curious beings so we often try to make sense of what’s going on around us. We attempt to explain our observations by making assumptions or hypotheses.
But of course, a hypothesis won’t mean anything until it is tested out. If empirical tests support our hypotheses, one could say that they become theories which are used to generate future observations.
The beauty of the scientific method is that it can teach us how to be humble. By always being open to new and fresh observations, scientists acknowledge the fact that their theories are not absolute truths. For them, having an open mind allows them to embrace the fact that human understanding will always fall short of nature’s complexities and makes them stay on their toes for new evidence that could challenge pre-existing theories.
For forex traders, this kind of open-mindedness could be an antidote to overconfidence and overtrading, allowing us to realize that it’s okay not to be right all the time. So how exactly can you trade like a scientist? Here are some steps that you can follow:
1. Observe the markets carefully and look for patterns.
As a forex trader, you should already have a basic understanding of the technical and fundamental factors that usually move the markets. You probably have an idea of how a particular economic event, such as an interest rate decision or a GDP release, could affect price action or how certain candlestick patterns signal that a reversal could be in the cards.
To gain an even better edge, you can add to your database of market factors by making careful observations and noting down recurring patterns. For instance, you recently observed that European bond price auctions tend to have a huge impact on risk sentiment and price action when euro zone debt woes are back in the spotlight. You can mark these events on your calendar to see how the market usually reacts.
2. Use these observations to create a hypothesis for price action.
Let’s say you’ve noticed that the U.S. dollar tends to rally when talks of Fed tightening dominate the airwaves and you want to take advantage of this forex price action later on. What you can do is note what actually happened, how dollar pairs reacted, and which trade setups could’ve enabled you to catch a part of that move.
You can keep listing down these observations in your trade journal until you are confident that your hypothesis is ready to be tested. Keep in mind that it would also be helpful to come up with a play-by-play commentary on price action, which could include the price action prior to the event, the initial reaction, and the main direction that the pair takes afterwards.
3. Put this hypothesis to the test by taking trades when similar patterns occur.
Once you have enough data supporting a particular forex pattern that you’ve observed, the next step would be to put this theory to the test by taking trades when the opportunity presents itself. Following my previous example about the U.S. dollar and policy tightening speculations, you can hunt for potential trades prior to a Fed announcement when central bank officials give testimonies.
Of course, deliberate practice would be very helpful in this aspect. As you take trades based on those patterns, you should also list down your new observations and whether you should make any adjustments on your hypothesis.
4. Don’t forget to keep an open mind.
Last but certainly not least, it is crucial to keep an open mind at all times. Remember that the markets are fickle and that your hypotheses are not absolute truths. As you’ve also probably observed during your trading experience, the forex market environment is very dynamic and sentiment can always shift on a dime.
With that, you should always be open for potential adjustments or completely new market patterns. Just like a good scientist, a good trader should remain open to new data. For instance, changes in the overall themes dominating the markets typically impact some currency pairs’ reaction to certain reports. There are even times when a currency pair doesn’t react to a high-impact report at all because there are bigger factors in play!
Keeping an open mind can also enable you to extend your hypothesis to accommodate other factors that could affect price action. Think about it as constantly fine-tuning your theories and trading plans!
By taking trading plans that are based on your observations and hypotheses, you can build confidence in taking those setups. With that, you can be more aggressive when those hypotheses are confirmed or more cautious when your observations are still shaky. This could also help you in risk management by knowing when to risk big or when to play it safe.
Also, by keeping a scientist’s mindset when trading, you’ll be able to treat each trade as a source of new information that could either enhance or disprove your theories. With that, you’ll be able to gain something even from losing trades as you use them, along with your winning ones, to develop a better understanding of the markets.