How to lose money when trading
DAVID Rodriguez, quantitative strategist for FXCM, spoke on the masters of forex panel at the Morning Wire Active Trader event last week. He pulled up the two charts to the right, which give a telling snapshot of the mentality of many traders, as well as what he cites as being the number one mistake made when trading.
As you can see from the first chart, on average, traders are right more than half of the time that they trade. But despite this, many traders still struggle to turn this winning ratio into a profit – but why? As Rodriguez explained to the those attending the conference, while traders are quick to cash in their winnings when the trade goes well, they have the tendency to stay in a losing trade longer than they should in the hope that the tide will change and their trade will come good.
The chart is based on data from FXCM, using a data set of over 12m trades conducted between 2009 and 2010. It shows the 15 most popular currency pairs that clients trade. For example, in euro-dollar, the most common currency pair, traders were profitable on 59 per cent of their trades and lost on 41 per cent. Though this data is from FX trades, you would see a similar chart if you lined up the 15 most traded UK equities, or 10 most traded commodities – the trend would remain the same. Traders often refuse to admit when they’re in a bad trade.
According to Rodriguez, the easy to prescribe, but sometimes difficult to adhere to rule is: cut your losses early, let your profits run. “Avoiding the loss-making problem is pretty simple. When trading, always seek a bigger reward than the loss you are risking. This is a valuable piece of advice that can be found in every trading book,” says Rodriguez.
The second chart displayed by Rodriguez at Morning Wire Active Trader demonstrates the example of a risk/reward ratio strategy with stop losses in place.
The “raw” system follows a fixed strategy, but without any stops and limits. The trades made using the raw system are profitable 65 per cent of the time during the measured period, but lost an average of $200 a time on losing trades, while making an average of only $121 on winning trades. The red line shows the same line set with stops set at 115 pips and the limit at 120 pips, keeping the risk/reward ratio on the right side of 1:1. The second strategy did not have quite the same impressive rate of profitable trades, but still achieved a rate of 59 per cent. But crucially, its positive trades made more money than its negative trades lost, resulting in profits.