Why do traders always need their own strategy

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Why Do Many Forex Traders Lose Money? Here is the Number 1 Mistake

W hy do major currency moves bring increased trader losses? To find out, the DailyFX research team has looked through over 40 million real trades placed via a major FX broker’s trading platforms. In this article , we look at the biggest mistake that forex traders make, and a way to trade appropriately .

Why Does the Average Forex Trader Lose Money?

The average forex trader loses money, which is in itself a very discouraging fact. But why? Put simply, human psychology makes trading difficult.

We looked at over 43 million real trades placed on a major FX broker’s trading servers from Q2, 2020 – Q1, 2020 and came to some very interesting conclusions. The first is encouraging: traders make money most of the time as over 50% of trades are closed out at a gain.

Percent of All Trades Closed Out at a Gain and Loss per Currency Pair

Data source: Derived from data from a major FX broker* across 15 most traded currency pairs from 3/1/2020 to 3/31/2020.

The above chart shows results of over 43 million trades conducted by these traders worldwide from Q2, 2020 through Q1, 2020 across the 15 most popular currency pairs. The blue bar shows the percentage of trades that ended with a profit for the trader. Red shows the percentage of trades that ended in loss. For example, the Euro saw an impressive 61% of all trades closed out at a gain. And indeed every single one of these instruments saw the majority of traders turned a profit more than 50 percent of the time.

If traders were right more than half of the time, why did most lose money?

Average Profit/Loss per Winning and Losing Trades per Currency Pair

Data source: Derived from data from a major FX broker* across 15 most traded currency pairs from 3/1/2020 to 3/31/2020.

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 being 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 see that EUR/USD trades were closed out at a profit 61% of the time, but the average losing trade was worth 83 pips while the average winner was only 48 pips. Traders were correct more than half the time, but they lost over 70% more on their losing trades as they won on winning trades. The track record for the volatile GBP/USD pair was even worse. Traders captured profits on 59% of all GBP/USD trades. Yet they overall lost money as they turned an average 43 pip profit on each winner and lost 83 pips on losing trades.

What gives? Identifying that there is a problem is important in itself, but we’ll need to understand the reasons behind it in order to look for a solution.

Cut Losses, Let Profits Run – Why is this So Difficult to Do?

In our study we saw that traders were very good at identifying profitable trading opportunities–closing trades out at a profit over 50 percent of the time. They utlimately lost, however, as the average loss far outweighed the gain. Open nearly any book on trading and the advice is the same: cut your losses early and let your profits run.

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.

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If a trade is in your favor, let it run . It is often tempting to close out at a small gain in order to protect profits, but oftentimes we see that patience can result in greater gains.

But if the solution is so simple, why is the issue so common? The simple answer: human nature. In fact this is not at all limited to trading. To further illustrate the point we draw on significant findings in psychology.

A Simple Wager – Understanding Human Behavior Towards Winning and Losing

What if I offered you a simple wager on a coin flip? You have two choices. Choice A means you have a 50% chance of winning 1000 dollars and 50% chance of winning nothing. Choice B is a flat 450 point gain. Which would you choose?

50% chance to Win 1000

50% chance to Win 0

Expect to win $500 over time

Over time it makes sense to take Choice A—the expected gain of $500 is greater than the fixed $450. Yet many studies have shown that most people will consistently choose Choice B. Let’s flip the wager and run it again.

50% chance to Lose 1000

50% chance to Lose 0

Expect to lose $500 over time

In this case we can expect to lose less money via Choice B, but in fact studies have shown that the majority of people will pick choice A every single time.

Here we see the issue. Most people avoid risk when it comes to taking profits but then actively seek it if it means avoiding a loss. Why?

Losses Hurt Psychologically far more than Gains Give Pleasure – Prospect Theory

Nobel prize-winning clinical psychologist Daniel Kahneman based on his research on decision making. His work wasn’t on trading per se but clear implications for trade management and is quite relevant to FX trading. His study on Prospect Theory attempted to model and predict choices people would make between scenarios involving known risks and rewards.

The findings showed something remarkably simple yet profound: most people took more pain from losses than pleasure from gains .

It feels “good enough” to make $450 versus $500 , but accepting a $500 loss hurts too much and many are willing to gamble that the trade turns around.

This doesn’t make any sense from a trading perspective—50 0 dollars lost are equivalent to 50 0 dollars gained; one is not worth more than the other. Why should we then act so differently?

Prospect Theory: Losses Typically Hurt Far More than Gains Give Pleasure

Taking a purely rational approach to markets means treating a 50 point gain as morally equivalent to a 50 point loss. Unfortunately our data on real trader behavior suggests that the majority can’t do this. We need to think more systematically to improve our chances at success.

Avoid the Common Pitfall

Avoiding the loss-making problem described above is very simple in theory: gain more in each winning trade than you give back in each losing trade. But how might we do it concretely?

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 “ reward/risk ratio ”. If you risk losing the same number of pips as you hope to gain, then your reward/risk ratio is 1-to-1 (also written 1:1). If you target a profit of 80 pips with a risk of 40 pips, then you have a 2:1 reward/risk 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. We recommend to always use a minimum 1:1 ratio . That way, if you are right only half the time, you will at least break even.

Certain strategies and trading techniques tend to produce high winning percentages as we saw with real trader data. If this is the case, it is possible to use a lower reward/risk ratio—such as between 1:1 and 2:1. For lower probability trading, a higher reward/risk ratio is recommended, such as 2:1, 3:1, or even 4:1. Remember, the higher the reward/risk ratio you choose, the less often you need to correctly predict market direction in order to make money trading. We will discuss different trading techniques in further detail in subsequent installments of this series.

Stick to Your Plan: Use Stops and Limits

Once you have a trading plan that uses a proper reward/risk 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 reward/risk 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 Using 1:1 Reward to Risk Really Work?

Our data certainly suggest it does. We use our data on our top 15 currency pairs to determine which trader accounts closed their Average Gain at least as large as their Average Loss—or a minimum Reward:Risk of 1:1. Were traders ultimately profitable if they stuck to this rule? Past performance is not indicative of future results, but the results certainly support it.

Our data shows that 53 percent of all accounts which operated on at least a 1:1 Reward to Risk ratio turned a net-profit in our 12-month sample period. Those under 1:1? A mere 17 percent.

Traders who adhered to this rule were 3 times more likely to turn a profit over the course of these 12 months—a substantial difference.

Data source: Derived from data from a major FX broker* across 15 most traded currency pairs from 3/1/2020 to 3/31/2020.

Game Plan: What Strategy Can 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 at least 1:1 regardless of strategy, potentially 2:1 or more in certain circumstances. 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 reward/risk 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 be at least 500 pips away.

We will use this as a basis for further study on real trader behavior as we look to uncover the traits of successful traders.

*Data is drawn from FXCM Inc. accounts excluding Eligible Contract Participants, Clearing Accounts, Hong Kong, and Japan subsidiaries from 3/1/2020 to 3/31/2020.

Interested in developing your own strategy? On page 2 of our Building Confidence in Trading Guide , we help you identify your trading style and create your own trading plan.

View the next articles in the Traits of Successful Series:

Analysis prepared and written by David Rodriguez, Quantitative Strategist for DailyFX.com

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

Why Do Most Forex Traders Lose Money?

Note: If You Really Enjoy My Forex Lessons, Could you please do me a ‘Huge favor’ after you have finished reading today’s forex lesson. Please click the Facebook Like button below this article, then click the twitter button / post it to twitter and facebook etc. You can even email it to a trading friend. Most importantly, make sure you make a nice comment with your feedback at the bottom. As I always say, If you get value from these lessons, all I ask is that you share it around with friends and other traders who will benefit from it. I appreciate your support and will talk soon. Enjoy this lesson. :) Nial.

Statistically speaking, trading the Forex market with a 1:1 risk reward ratio and no strategy or trading edge has a 50% chance of success (minus fees) over a long series of trades. Thus, most traders should approximately breakeven over the long run because trading with a (truly) random entry and a 1:1 risk reward is analogous to a random coin toss.

Why do most Forex traders lose money then? What human variables contribute to the success rate being much lower than breakeven for most traders?

Perhaps the main reason most traders lose money is because the majority of people have little self-control and cannot resist the temptation to over-trade and over-leverage when there is no one to be accountable to. Another main reason most traders lose money is because they try to buck the trend for some reason, even though they KNOW they have a statistically higher chance of winning by sticking with the trend until it is clearly finished. In this article I will share with you my thoughts on why otherwise totally rational and successful people fall apart when it comes to trading the Forex market.

• Not accepting responsibility for losses and mistakes

As human beings we all have a tendency to pass the blame and find fault elsewhere. However, when you are trading badly, it is your fault and no one else’s. If you find you are losing money in the markets it is not your broker’s fault, nor is it the result of a bad quote, a bad tip, or a hardware failure. There is no mysterious “They” out to get you or steal your money from you. Everything that happens to you in the market, good or bad, is ultimately your fault; blaming anyone else or thing is not going to help you become a successful trader.

Accepting responsibility for your losses and trading mistakes is paramount to turning your trading around. If you use a “tip” or a piece of advice from a broker or from someone else, and you lose money as a result, it’s your fault for listening to them; at least the second time around. The first step in any self-help group like Alcoholics Anonymous is admitting you are the problem and that you have a problem. If you continually blame other people or things for your trading losses, you will never improve your trading because you won’t feel any need to correct your weaknesses if you don’t believe you have any. So, a big reason many traders fail to make money is because they won’t admit they are to blame for their losses. If you want to improve your trading you need to take full responsibility and go into Forex traders’ rehab.

• Over-trading and not trading higher time frames

One thing that definitely prevents most traders from making money in the market is over-trading. Traders who just jump in and out of the market on emotion and greed, will not only suffer many more losing trades, but they will also rack up a lot more fees via spreads and (or) commissions over the course of a year than traders who stick to the higher time frames and understand the value of self discipline and having patience. Trading lower time frames causes many traders to over-trade because they end up thinking they see many more trading signals worth trading, when in reality there is just a lot more “junk” signals and “noise” on lower time frames.

So, if you are currently losing money on a consistent basis and you are trading lower time frames, you will definitely benefit by switching to higher time frame Forex trading.

• Risking too much

How many times have you won a few trades in a row, made some money, and then given it all back quicker than you made it? This happens all too often for traders who have not yet learned to risk the same amount every trade or who have not yet learned to manage their emotions effectively. Trading should not be viewed or treated as gambling, you don’t want to “double down” just because you are up some money. That is not how it works. You have to stop and ask yourself, “Are you a Forex Trader or Gambler?”

As price action traders, our aim is to “master” our trading strategy to the point of knowing exactly what we are looking for in the market every time we sit down behind our computer screen. However, just because you know exactly WHAT you are looking for in the market, this does NOT mean that it WILL work out. Price action trading gives you an “edge”, just like any other method does (although price action is clearly the best way to trade), and what you need to understand is that no matter what your edge is, it’s not going to work out in your favor EVERY time, and you don’t know for sure if any single edge-event will work out.

So, if you are equally confident in every trade you take, because you have mastered price action trading, there really is no reason to risk substantially more or less on any single trade. You want to keep your risk amount approximately constant relative to your total account value. The only time you should increase your risk per trade is if your account value increases, never increase risk per trade just because you feel “totally certain” that THIS trade will work out, because as we discussed above, YOU DON’T KNOW if it will or not.

• Poor Forex trade management / no trade management

If there is one single thing that most traders do wrong who lose money on a consistent basis, it is poor trade management. Every trader knows after a little practice and education on a high-probability trading method like price action, they can pick near-term market direction with pretty good accuracy, at least enough to get into open profit. This is not the hard part of trading. The hard part comes after you enter a trade. Most traders have no forex trade management plan, either because they don’t understand trade management, or don’t think they need to do it. What these traders don’t understand is that they are sabotaging their own effort and potential skill as a trader by thinking they will somehow behave more logically and effectively AFTER entering a trade than BEFORE. This is just ridiculous. No human being on Earth will be more objective or less emotional than they will be when there money is NOT on the line. It’s a fact of human psychology that when something you care about (money, relationship, etc) is at risk, you become more emotional. Everyone knows this. So, if you are guilty of not managing your trades BEFORE entering them, accept responsibility right now and start changing it.

A related topic here is having a Forex trading plan. Your trade management plan should just be one part of your overall Forex trading plan. If you don’t have a written down plan of attack on how you will trade the markets, you are probably going to go nowhere fast. Your trading plan should also include a Forex trading journal.

• Entering randomly / not mastering a proven method

Traders who don’t have a definable and “mastered” trading method are hurting themselves because they essentially have no trading edge and are just shooting in the dark, so to speak. When you learn one effective trading strategy like price action, and truly master one Forex trading strategy at a time, you will largely eliminate the problem of fear and second guessing your own trades. The key here is that you REALLY NEED TO MASTER an effective trading strategy, like price action. Most aspiring traders just jump around from one trading strategy or system to the next, never really giving one enough time to truly master it. So, the first thing is that you need a truly effective trading strategy, and then you have to give it enough time to truly master it.

Human beings have a tendency to see patterns that don’t really mean anything. This is especially true in trading; if you stare at a chart long enough you can make up all kinds of things that “should” happen based on what you “see”. The bottom line is that price action strategies really do give you the edge you need, so that you aren’t guilty of “manifesting” irrelevant patters in the market, but you HAVE to put in the time and get the education required to master them.

• Unrealistic expectations

Finally, one thing that is definitely common to all traders who are losing money in the markets is that they have unrealistic expectations. If you have $500 to trade with, there is no way on Earth you are going to be able to live off your trading. You have to take into consideration what you can REALISTICALLY expect to make each month or week, given the amount of money you have to trade with. This is assuming you will commit to effective Forex money management, because if you are properly managing your risk on every single trade, there is just no way you can make enough money to live on if you don’t already have a lot of money to trade with.

This doesn’t mean you can’t be a successful trader however. Being a successful trader means you are consistently making money in the markets. If you have a small trading account but are making consistent profits that are in-line with your small account, then you ARE a successful trader. The same habits that make a trader successful on a small account are the SAME habits of successful traders of large accounts. Remember that. Forex trading success is not measured by whether or not you get-rich-quick, it is measured by your consistency, and the only way you can become consistent is if your expectations are in-line with the reality of your current financial situation and the reality of the markets.

Traders and Brokers: Bud Fox vs. Gordon Gekko?

Assuming you’ve seen Wall Street (the awesome, original one, not the watered-down sequel) – it is a requirement to work in finance, after all – you know something about traders vs. brokers.

The traders are like lone wolves who go in and make tons of money by making quick decisions…

But supporting every successful trader is his/her broker – the one who actually connects buyers and sellers and makes trades go through.

Both traders and brokers are linked to the market and need to stay on top of everything that’s happening – but beyond that, they’re quite different.

So, what do traders and brokers actually do?

Which one is a better match for your personality? How do you break in?

And most importantly, who makes more money?

Definitions and Types of Traders

You might remember from the guide to fixed income trading that we defined 2 types of trading: agency trading, where you simply execute orders for the client, and prop trading, where you invest the firm’s own money and make your own trading decisions.

But the outside world has no idea what those terms mean, so they usually refer to prop traders as “traders” and agency traders as “brokers,” which is what we’re sticking to here.

Prop traders exist at dedicated prop trading firms and hedge funds, and they used to exist at investment banks before the US government banned them (the verdict is still out on other countries).

Brokers exist at both banks and at independent firms called brokerages; the difference is that these smaller agency-brokers are pure middlemen and only fulfill orders while large banks have a lot more going on.

There’s more to it than that and as with other areas of trading, the dividing lines can get blurry, but that’s the basic difference and how we’ll be using the terms here.

  • Gordon Gekko – Trader
  • Bud Fox – Broker

OK, back to how they’re different…

What Do Traders Do?

Traders are at the top of the food chain – entire teams in the back and middle office support all their trades and fix annoying IT issues for them.

They analyze equities, derivatives, fixed income, forex, commodities, and anything else they might be trading and decide on what to trade, what strategies to pursue, and how to invest the firm’s money.

If the trading floor were a jungle, traders would be gorillas who pound their chest constantly while stealing bananas from everyone else.

Everyone wants to be a trader, but it’s tough unless you have the right education, background, and personal connections.

Brokers – Support Staff?

After a trader decides what to buy or sell, he would call the broker and say, “I want to buy/sell XX of XX – can you make it happen?”

Technically, brokers “support” the traders but they’re completely different from the back and middle office crew.

Unlike the back and middle office, brokers generate revenue – they connect buyers and sellers and make a commission on each successful transaction.

The more shares that a trader trades through the broker, the more money the broker makes – and the more traders the broker services, the more money he makes.

Personalities – Traders

Traders are judged almost 100% on performance – it’s one of the few professions on Wall Street where you can excel even if you show up without shaving for a week or two.

If you bring in massive profits for the firm, you’ll be rewarded.

Traders spend most of the day in front of their 8 or so computer screens – they might discuss ideas and market news with other traders, but overall there’s less teamwork than in management consulting or investment banking.

So the trading profession attracts more introverted individuals who are good at math and great at working independently: think math and engineering majors, with a few random frat boys thrown in for good measure.

Brokers: Got Extrovert?

For brokers, it’s all about relationships and networking: you’re judged based on your ability to bring in traders and keep them on board.

Profit still matters, but the quality and quantity of clients you bring in also plays a big role.

If you’re a good schmoozer and you’re always the first to hear about rumors and gossip, you’d be a great broker.

If Malcolm Gladwell were writing a new column about traders and brokers, brokers would be part-maven, part-connector – they know everyone, and they track of tidbits of information to entertain and inform traders.

If a client really liked Turkish food, a broker would know all the best Turkish restaurants within a 5 km radius.

There’s a lot of back-and-forth with traders on the phone during the day, so brokers often invite traders out for food, drinks, and sports (and sometimes “other forms of entertainment”) after work.

Breaking In: Trading vs. Brokering

Large banks do take sales & trading summer interns and make S&T full-time hires, but the numbers are lower than what you see in investment banking.

Major trading desks such as credit, equity, and forex might only hire 1 or 2 per desk – whereas in banking, groups like ECM or M&A might take on 5-10+ new analysts depending on the team size.

With the 2020 financial reform, those numbers will shrink even further as banks disband their prop trading groups and everyone migrates to hedge funds.

For networking, resumes, and interviews for trading, check out our coverage of sales & trading vs investment banking – there are significant differences, especially in interviews.

With brokers, there’s even more of a focus on experienced hires: on-campus recruiting is rare, especially for smaller agency-brokers, and you pretty much have to network your way in from related fields.

Some brokers also post ads online and if you have the right experience, applying online might actually work – that’s because they’re looking for very specific experience and as you move up, you get more and more specialized.

Resumes and interviews are similar to trading at the entry-level, though there may be more of a focus on relationships and sales skills – similar to sales itself – at dedicated firms.

Potential Advancement

Advancement depends on how business is going: if your desk is profitable, wants to expand, and everyone likes you, then they might give you your own portfolio or trading book once you’ve proven yourself.

Note that even as you “advance” within trading, your actual work may not change that much – you’re still trading all day.

It’s not like investment banking where MDs are wining and dining clients and analysts are pumping out pitch books – you just get more responsibility and a higher percentage of the profits.

On the brokerage side, advancement and upside depend on how many new clients you can bring in and the commissions you generate – just like with trading, the work itself doesn’t change dramatically as you move up but you work with higher-volume clients and earn more.

Work Hours

Work hours are roughly the same for traders and brokers – they get in an hour or two before the market opens and leave an hour or two after market close.

Brokers might try to get in earlier than traders and leave after the traders leave just to make themselves available at all times.

Both are completely different from investment banking: no all-nighters and no 100-hour workweeks.

Think 60-70 hours per week rather than 90-100.

Who Makes More Money?

And now to the $50 million (or should that be billion?) question.

Most people would say, “Traders make more money!”

After all, some traders make tens of millions per year, and then there are special cases like John Paulson – he made over $2 billion in cash each year in 2008-2009 by betting against subprime mortgages and CDOs.

No one noticed or cared what his broker made.

The problem is that everyone focuses on these once-in-a-lifetime success stories rather than the average trader: for every profitable trader, there’s a trader somewhere else that lost money.

Meanwhile, the broker in between made decent money even if one of the traders did not.

Multiply this by dozens of trading clients and you can see how broker commissions can add up to a comfortable lifestyle, all with far less market risk.

Specific Numbers, Please

Numbers are tough to verify, but most brokers start in the mid 5-figures range and the most successful brokers might be in the mid 6-figures range – it’s not like trading where the stars could make in the tens or hundreds of millions or billions of USD each year.

If you want to believe Salary.com, they have a nice graph here.

Keep in mind that the average (prop) trader makes nowhere close to that each year – some small prop trading firms don’t even pay you a salary and instead base everything on your trading performance, so you could end up with a “paycheck” of $0.

The maximum pay for traders is a completely different order of magnitude, but the standard deviation is also much higher – so the median pay may not be much different between traders and brokers at the entry-level.

And don’t underestimate how much you can make as a broker: brokerage firms often make more than trading firms that are suffering from a lackluster year.

Are the Machines Taking Over?

You’ve probably read about how trading is becoming more and more automated – should you even bother getting into the industry if computers will take over anyway?

Keep in mind that there will always be a human element – someone needs to program algorithms in the first place and continually test the programs.

So it’s not as if the industry is dying – it’s just shifting in more of a quantitative direction.

Even on the brokerage side, more and more agency trading activity is becoming computerized as well – there will always be a need for the outgoing broker who knows everyone, but the math nerd might not be far behind him.

This article was guest-written by Zeke Lee, a Stanford graduate, former management consultant with Booz & Company and former derivatives trader on Wall Street (Oh yeah, he’s one of my friends from school as well).

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