What Was My Friend Doing Wrong
Wednesday 10 November 2010
Recently, a close friend of mine who knows me for years admitted to me that he lost over $21,000 on forex market in less than three months time. Well, there would be nothing strange about it if there wasn't one very important fact. He is my friend and he knows that I'm a forex trader. I asked him why didn't he consult me when he was starting, actually I was very disappointed that he hid from me the fact that he was involved in forex. He told me that every time he heard me talking about forex, I was always using words such as "hard", "stressful", "dangerous"... He said that he didn't like to hear those words.
So one evening he was surfing the web and he stumbled upon one site that he says "stood out". Everything that he read on that site was completely opposite of anything that he heard from me. "Forex trading is easy...", "Anyone can do it with just a little bit of effort...", "You can quit your day job...". And he was hooked. He bought their system and opened demo account. His demo account was set at $50,000, few lucky trades over the next four weeks and his demo account grew to $78,000. Wow! Twenty eight thousand dollars in four weeks. As any other beginner he was thrilled. He withdrew $10,000 from his hard earned savings account and he was all set to accomplish his dreams.
However, very soon he realized that trading for real money and trading demo account have nothing in common. When real money got at stake, he became different person. Nervous, scared, he took his profits way too early and stayed in losing trades far more than he was supposed to. His money was melting before his eyes! He added another $5,000. Then he borrowed another ten thousand from his line of credit. He came to me when he was down to the last three thousand and nine hundred dollars.
What was the first advice that I gave to my friend
After spending a few hours talking to him, reviewing his system and listening to his trading experiences I came to the following conclusions.
There were THREE MAJOR problems with his trading method:
The efficiency (profitability) of the system is not based on the QUANTITY of signals that it produces. It is based on the QUALITY of entry signals that it produces. The entry signal needs to put probability of a trade moving into your desired direction on YOUR side. His signals were working AGAINST him.
- His system was relying on lagging indicators
Most of the indicators that his system was using were so called lagging indicators. Basically, it means that he was always the last one to enter a profitable trade and the last one to get out of a losing trade.
- His system was not clearly defined
The system needs to have a clear set of entry and exit rules. It can not be left up to the trader's discretion to decide when to enter the trade and when to get out. In the real, professional system, you MUST enter the trade when the signal occurs, because that is where your winning edge is in the long run.
You can not and should not trade with "scared" money. You can only trade with the money that you can afford to lose. That will make you calm and therefore less likely to make a bad judgment.
- He was getting out of winning trades too early
Even when his entry signals were good he was not able to extract maximum profit from them. The MANTRA is "let your profits run". It is not "cut your profits short". You need to extract MAXIMUM profit from EVERY single trade in order to be profitable in the long run.
For example, let's say that current opinion is that Central Bank will rise interest rates by .25 points on the next meeting. And they actually raise it by .50 points. If the sentiment for that particular currency was bullish or even neutral, it would definitely trigger that particular currency to go higher. However, if the sentiment was negative, all that would happen is that sell off of that currency would stop for short period of time and then it would resume.
So, why is the sentiment important?
Sentiment is by far the most important tool at the hands of forex trader. Why is it so? Because it gives to the forex trader a clue when NOT to take particular trading signal. The power of successful forex trader is to know when NOT to participate in the trade.
How this applies to you?
Let's say that you own a trading strategy that generates either bullish or bearish signals for the particular currency pair. Sentiment will help you determine whether to take the signal or to stay on the sidelines. If the signal is bearish but current sentiment is bullish, you DO NOT take the signal. If the signal is bullish but current sentiment is bearish, you DO NOT take the signal. You only take the signal if it is confirmed by current sentiment.
I hope that you have learned something from my friend's mistakes.
So what's their secret?
Do winning forex traders have some special talent?
Have they found some inside knowledge and locked the rest of us out?
Do they have a knack of thinking "positive" or thinking "winning"?
Are their computer more powerful and their trading software more sophisticated?
What is it?
Well... it's none of the above!
Let's have a look at the figure below.
Let's discuss for moment a chart about greed, panic and fear that you just saw above.
The typical beginner trader moves with the "herd".
He sees a rally, doesn't want to be left out, and enters the market at point A.
However, by then, winning traders, who were in earlier, start to cash in on their profits and the rally loses steam.
So the beginner's position falls. His money is dissolving before his eyes!
Either he panics and gets out at point B, when he can't bear the pain any more. Or, if he somehow manages to stay in long enough to see the next rally, he leaves at point C, relieved to recover at least some of his losses.
This is exactly the kind of "herd" trader that successful traders prey upon.
But actually the beginner also lost at point C.
Because during that exact same move the winning traders had leveraged their trading capital, entered and exited at the optimum times, and stuffed their accounts with profits!
If you want to learn how to enter and leave like the winners do, you should keep reading.
So one evening he was surfing the web and he stumbled upon one site that he says "stood out". Everything that he read on that site was completely opposite of anything that he heard from me. "Forex trading is easy...", "Anyone can do it with just a little bit of effort...", "You can quit your day job...". And he was hooked. He bought their system and opened demo account. His demo account was set at $50,000, few lucky trades over the next four weeks and his demo account grew to $78,000. Wow! Twenty eight thousand dollars in four weeks. As any other beginner he was thrilled. He withdrew $10,000 from his hard earned savings account and he was all set to accomplish his dreams.
However, very soon he realized that trading for real money and trading demo account have nothing in common. When real money got at stake, he became different person. Nervous, scared, he took his profits way too early and stayed in losing trades far more than he was supposed to. His money was melting before his eyes! He added another $5,000. Then he borrowed another ten thousand from his line of credit. He came to me when he was down to the last three thousand and nine hundred dollars.
What was the first advice that I gave to my friend
After spending a few hours talking to him, reviewing his system and listening to his trading experiences I came to the following conclusions.
There were THREE MAJOR problems with his trading method:
1. His Trading "System"
- His system was producing way too many entry signalsThe efficiency (profitability) of the system is not based on the QUANTITY of signals that it produces. It is based on the QUALITY of entry signals that it produces. The entry signal needs to put probability of a trade moving into your desired direction on YOUR side. His signals were working AGAINST him.
- His system was relying on lagging indicators
Most of the indicators that his system was using were so called lagging indicators. Basically, it means that he was always the last one to enter a profitable trade and the last one to get out of a losing trade.
- His system was not clearly defined
The system needs to have a clear set of entry and exit rules. It can not be left up to the trader's discretion to decide when to enter the trade and when to get out. In the real, professional system, you MUST enter the trade when the signal occurs, because that is where your winning edge is in the long run.
2. His Mind Set
- He was always stressed out when his real money was inside the tradeYou can not and should not trade with "scared" money. You can only trade with the money that you can afford to lose. That will make you calm and therefore less likely to make a bad judgment.
- He was getting out of winning trades too early
Even when his entry signals were good he was not able to extract maximum profit from them. The MANTRA is "let your profits run". It is not "cut your profits short". You need to extract MAXIMUM profit from EVERY single trade in order to be profitable in the long run.
3. He did not pay attention to SENTIMENT
The forex market sentiment is the "collective" and intuitive opinion or better to say "gut feeling" that is formed inside the forex trading community regarding the future direction of a given currency pair (EUR/USD, USD/CAD, GBP/USD, etc..). I'm sure that all of you who are already involved in the forex market have noticed that sometimes, when market sentiment is negative for the particular currency, even the best news can do nothing more than temporarily stop the negative direction of that currency.For example, let's say that current opinion is that Central Bank will rise interest rates by .25 points on the next meeting. And they actually raise it by .50 points. If the sentiment for that particular currency was bullish or even neutral, it would definitely trigger that particular currency to go higher. However, if the sentiment was negative, all that would happen is that sell off of that currency would stop for short period of time and then it would resume.
So, why is the sentiment important?
Sentiment is by far the most important tool at the hands of forex trader. Why is it so? Because it gives to the forex trader a clue when NOT to take particular trading signal. The power of successful forex trader is to know when NOT to participate in the trade.
How this applies to you?
Let's say that you own a trading strategy that generates either bullish or bearish signals for the particular currency pair. Sentiment will help you determine whether to take the signal or to stay on the sidelines. If the signal is bearish but current sentiment is bullish, you DO NOT take the signal. If the signal is bullish but current sentiment is bearish, you DO NOT take the signal. You only take the signal if it is confirmed by current sentiment.
I hope that you have learned something from my friend's mistakes.
A Chart About Greed, Panic and Fear
When you're starting out, one of things you discover is that only a few forex traders actually scoop profits out of the market consistently. Just a tiny minority. Everyone else is losing, or just breaking even.So what's their secret?
Do winning forex traders have some special talent?
Have they found some inside knowledge and locked the rest of us out?
Do they have a knack of thinking "positive" or thinking "winning"?
Are their computer more powerful and their trading software more sophisticated?
What is it?
Well... it's none of the above!
Let's have a look at the figure below.
Let's discuss for moment a chart about greed, panic and fear that you just saw above.
The typical beginner trader moves with the "herd".
He sees a rally, doesn't want to be left out, and enters the market at point A.
However, by then, winning traders, who were in earlier, start to cash in on their profits and the rally loses steam.
So the beginner's position falls. His money is dissolving before his eyes!
Either he panics and gets out at point B, when he can't bear the pain any more. Or, if he somehow manages to stay in long enough to see the next rally, he leaves at point C, relieved to recover at least some of his losses.
This is exactly the kind of "herd" trader that successful traders prey upon.
But actually the beginner also lost at point C.
Because during that exact same move the winning traders had leveraged their trading capital, entered and exited at the optimum times, and stuffed their accounts with profits!
If you want to learn how to enter and leave like the winners do, you should keep reading.
Labels:
Trading Strategies