What
is the Number One Mistake Forex Traders Make?
By David Rodriguez,
Quantitative Strategist and Timothy Shea,
Summary: Traders are right
more than 50% of the time, but lose more money on losing trades than they win
on winning trades. Traders should use stops and limits to enforce a risk/reward
ratio of 1:1 or higher.
Big US Dollar moves
against the Euro and other currencies have made forex trading more popular than
ever, but the influx of new traders has been matched by an outflow of existing
traders.
Why do major currency
moves bring increased trader losses? To find out, the DailyFX research team has
looked through amalgamated trading data on thousands of FXCM live accounts. In
this article, we look at the biggest mistake that forex traders make, and a way
to trade appropriately.
David Rodriguez,
Quantitative Strategist at DailyFX presented this research at the 2011 FXCM
Currency Trading Expo. Watch the video at fxcmexpo.com.
Why Does the Average Forex Trader Do Wrong?
Many forex traders have
significant experience trading in other markets, and their technical and fundamental
analysis is often quite good. In fact, in almost all of the most popular
currency pairs that FXCM clients trade, traders are correct more than
50% of the time:
The above chart shows the
results of a data set of over 12 million real trades conducted by FXCM clients
worldwide in 2009 and 2010. It shows the 15 most popular currency pairs that
clients trade. The blue bar shows the percentage of trades that ended with a
profit for the client. Red shows the percentage of trades that ended in loss.
For example, in EUR/USD, the most popular currency pair, FXCM clients in the
sample were profitable on 59% of their trades, and lost on 41% of their trades.
So if traders tend to be
right more than half the time, what are they doing wrong?
The above chart says it
all. In blue, it shows the average number of pips traders earned on profitable
trades. In red, it shows the average number of pips lost in losing trades. We
can now clearly see why traders lose money despite bring right more than half
the time. They lose more money on their losing trades than they make on
their winning trades.
Let’s use EUR/USD as an
example. We know that EUR/USD trades were profitable 59% of the time, but
trader losses on EUR/USD were an average of 127 pips while profits were only an
average of 65 pips. While traders were correct more than half the time, they
lost nearly twice as much on their losing trades as they won on winning trades
losing money overall.
The track record for the
volatile GBP/JPY pair was even worse. Traders were right an impressive 66% of
the time in GBP/JPY – that’s twice as many successful trades as unsuccessful
ones. However, traders overall lost money in GBP/JPY because they made an
average of only 52 pips on winning trades, while losing more than twice that –
an average 122 pips – on losing trades.
Cut Your Losses Early, Let Your Profits Run
Countless trading books
advise traders to do this. When your trade goes against you, close it out. Take
the small loss and then try again later, if appropriate. It is better to take a
small loss early than a big loss later. Conversely, when a trade is going well,
do not be afraid to let it continue working. You may be able to gain more profits.
This may sound simple –
“do more of what is working and less of what is not” – but it runs contrary to
human nature. We want to be right. We naturally want to hold on to losses,
hoping that “things will turn around” and that our trade “will be right”.
Meanwhile, we want to take our profitable trades off the table early, because
we become afraid of losing the profits that we’ve already made. This is how you
lose money trading. When trading, it is more important to be profitable than to
be right. So take your losses early, and let your profits run.
How to Do It: Follow One Simple Rule
Avoiding the loss-making
problem described above is pretty simple. When trading, always follow one
simple rule: always seek a bigger reward than the loss you are risking. This is
a valuable piece of advice that can be found in almost every trading book.
Typically, this is called a “risk/reward ratio”. If you risk losing the
same number of pips as you hope to gain, then your risk/reward ratio is 1-to-1
(sometimes written 1:1). If you target a profit of 80 pips with a risk of 40
pips, then you have a 1:2 risk/reward ratio. If you follow this simple rule,
you can be right on the direction of only half of your trades and still make
money because you will earn more profits on your winning trades than losses on
your losing trades.
What ratio should you
use? It depends on the type of trade you are making. You should always use
a minimum 1:1 ratio. That way, if you are right only half the time, you
will at least break even. Generally, with high probability trading strategies,
such as range trading strategies, you will want to use a lower ratio, perhaps
between 1:1 and 1:2. For lower probability trades, such as trend trading
strategies, a higher risk/reward ratio is recommended, such as 1:2, 1:3, or
even 1:4. Remember, the higher the risk/reward ratio you choose, the less often
you need to correctly predict market direction in order to make money trading.
Stick to Your Plan: Use Stops and Limits
Once you have a trading
plan that uses a proper risk/reward ratio, the next challenge is to stick to
the plan. Remember, it is natural for humans to want to hold on to losses and
take profits early, but it makes for bad trading. We must overcome this natural
tendency and remove our emotions from trading.The best way to do this is to
set up your trade with Stop-Loss and Limit orders from the beginning. This
will allow you to use the proper risk/reward ratio (1:1 or higher) from the
outset, and to stick to it. Once you set them, don’t touch them (One
exception: you can move your stop in your favor to lock
in profits as the market moves in your favor).
Managing your risk in
this way is a part of what many traders call “money management”.
Many of the most successful forex traders are right about the market’s
direction less than half the time. Since they practice good money management, they cut their losses
quickly and let their profits run, so they are still profitable in their
overall trading.
Does This Rule Really Work?
Absolutely. There is a
reason why so many traders advocate it. You can readily see the difference in
the chart below.
The 2 lines in the chart
above show the hypothetical returns from a basic RSI trading strategy on
USD/CHF using a 60 minute chart. This system was developed to mimic the
strategy followed by a very large number of FXCM clients, who tend to be range
traders. The blue line shows the “raw” returns, if we run the system without
any stops or limits. The red line shows the results if we use stops and limits.
The improved results are plain to see.
Our “raw” system follows
FXCM clients in another way – it has a high win percentage, but still loses
more money on losing trades than it gains on winning ones. The “raw” system’s
trades are profitable an impressive 65% of the time during the test period, but
it lost an average $200 on losing trades, while only making an average $121 on
winning trades.
For our Stop and Limit
settings in this model, we set the stop to a constant 115 pips, and the limit
to 120 pips, giving us a risk/reward ratio of slightly higher than 1:1. Since
this is an RSI Range Trading Strategy, a lower risk/reward ratio gave us better
results, because it is a high-probability strategy. 56% of trades in the system
were profitable.
In comparing these two
results, you can see that not only are the overall results better with the
stops and limits, but positive results are more consistent. Drawdowns tend to
be smaller, and the equity curve a bit smoother.
Also, in general, a
risk/reward of 1-to-1 or higher was more profitable than one that was lower.
The next chart shows a simulation for setting a stop to 110 pips on every
trade. The system had the best overall profit at around the 1-to-1 and 1-to-1.5
risk/reward level. In the chart below, the left axis shows you the overall
return generated over time by the system. The bottom axis shows the risk/reward
ratios. You can see the steep rise right at the 1:1 level. At higher risk/rewards
levels, the results are broadly similar to the 1:1 level.
Again, we note that our
model strategy in this case is a high probability range trading strategy, so a
low risk/reward ratio is likely to work well. With a trending strategy, we
would expect better results at a higher risk/reward, as trends can continue in
your favor for far longer than a range-bound price move.
Game Plan: What Strategy Should I Use?
Trade forex with stops
and limits set to a risk/reward ratio of 1:1 or higher
Whenever you place a
trade, make sure that you use a stop-loss order. Always make sure that your
profit target is at least as far away from your entry price as
your stop-loss is. You can certainly set your price target higher, and probably
should aim for 1:2 or more when trend trading. Then you can choose
the market direction correctly only half the time and still make money in your
account.
The actual distance you
place your stops and limits will depend on the conditions in the market at the
time, such as volatility, currency pair, and where you see support and
resistance. You can apply the same risk/reward ratio to any trade. If you have
a stop level 40 pips away from entry, you should have a profit target 40 pips or
more away. If you have a stop level 500 pips away, your profit target
should beat least 500 pips away.
DailyFX Resources for Successful Money
Management
The DailyFX Trading
Instructors have years of experience trading the markets and helping thousands
of new traders learn forex. Here are a few of their many tips that can help you
trade better by improving your money management:
Exclusive for FXCM Clients: Sign Up for Live
Classes
FXCM Clients can take
free interactive classes via the DailyFX PLUS Trading Course.
Model Strategy:
For our models in this article,
we simulated a “typical trader” using one of the most common and simple
intraday range trading strategies there is, following RSI on a 15 minute chart.
Entry Rule: When the 14-period
RSI crosses above 30, buy at market on the open of the next bar. When RSI
crosses below 70, sell at market on the open of the next bar.
Exit Rule: Strategy will exit
a trade and flip direction when the opposite signal is triggered.
When adding in the stops
and limits, the strategy can close out a trade before a stop or limit is hit,
if the RSI indicates that a position should be closed or flipped. When a Stop
or Limit order is triggered, the position is closed and the system waits to
open its next position according to the Entry Rule.
The Traits of Successful Traders
Over the past several months, the DailyFX research team has been closely studying the trading trends of FXCM clients, utilizing trade data from FXCM. We have gone through an enormous number of statistics and anonymized trading records in order to answer one question: “What separates successful traders from unsuccessful traders?”. We have been using this unique resource to distill some of the “best practices” that successful traders follow, such as the best time of day, appropriate use of leverage, the best currency pairs, and more.
No comments:
Post a Comment