Thursday, March 24, 2011
A trading plan is a must. I would be will to bet that virtually all successful traders have one. However, most new traders have no plan. In fact, I bet most new traders barely even have actual reasons for entering a trade. Imagine that you are planning to loan money to a new business as an investment. Could you picture yourself lending money to this person if they had no business plan and said they were going to start their business based on "their gut"? Of course a person would never be able to start a business by relying only on their gut. However, plenty of new traders start trading in exactly that manner.
Creating a trading plan is actually relatively easy. There are several core requirements that make up the plan. In my opinion, the main components of a trading plan are:
Wednesday, March 23, 2011
Entering a trade is an important step in the trading process. It is wise to have a predetermined entry, stop, and profit target(s). However, picking the proper enter is not the only key to experiencing trading success. Even with a planned stop and a planned profit target, any seasoned trader knows it is possible to lose money even if the entry was at the perfect point and the profit target was at the perfect point. This gap between what the result of a trade result "should be" and what the actual results are can be significant, especially for novice traders.
So why does this gap exist between what returns "should be" and the actual results? I believe a critical cause of this phenomenon is the refusal of traders to be patient once they enter a position. Many traders feel that they should always be doing something when they are trading. Others feel that they want to continually update their stop and profit target to gain an extra edge. These feelings become dangerous when managing an open position, because it leads to mistakes that could be avoided by patiently sitting tight. Traders experiencing this feeling are prone to making several trading mistakes, which will be outlined below.
First, many traders are prone to taking a loss by manually exiting a position early. Let's say that our trader has entered their position and has a stop in place. So far so good. But the position starts going against the trader. They get scared and exit the position with a market order just before the pair closes in on the stop. In their head they think that they just saved a little capital because the pair was probably going to get stopped out anyway. However, that tiny amount of money they may save is nothing compared to the amount of profit they could earn if the pair reversed and went to the profit target. Looking at this from a risk:reward perspective, it is not worth gain a few extra dollars while giving up the potential for a large profit. The goal of stop placement should be to put the stop where the trade is "wrong". Therefore, if the trade hasn't reached the stop, it should be considered "wrong" yet. Therefore, why would anyone prematurely liquidate their position?
Second, many traders are prone to taking a gain by manually exiting a positing early. Again, let's say that our trader has entered their position and has a profit target limit in place. Again, so far so good. The position is going in their favor, but then it starts reverse and head back to their entry. The trader gets scared and exits the position for a tiny profit while thinking to himself that no trader every has gone broke taking a profit. Well, of course, that is a ridiculous statement. Think of it this way: if a trader won 99 straight trades for a profit of $1 each and then lost $10,000 on their 100th trade, does it matter that their winning percentage was 99%? Of course not, because they lost more on balance than they won. Taking profits prematurely may feel good on an individual trade basis, but usually it leads to a poor p/l in the long run. Once a trader has figured out their profit target, that should be the target to shoot for.
Tuesday, March 22, 2011
I often hear beginning traders speak as if they know what the markets will do next. In reality, experienced traders usually speak in probabilities and typically have some form of analysis to back up their opinion. No one can say that a particular currency pair (or other financial instrument) will move to an exact point with absolute certainty. In fact, I feel it is naive to think that anyone can predict the direction of a currency pair with absolute certainty over a given period of time. Sure, sometimes you could be correct if you boldly predict that a pair will move to X level with absolute certainty. However, there will be other times when the market doesn't go your way. That is why we must deal with probabilities, because no one knows for sure what will happen next in a given currency pair.
The reason we can never know where a currency pair with absolutely certainty is that the markets move based on the will of every market participant. Let's suppose that someone stated "the EUR/USD will definitely rise to point X, before falling down to point Y". They are saying that know exactly what every market participant (or trader) is thinking, how each of these participants plans to act, and how each participant will respond to the actions of every other participant. Needless to say, no one could ever have that information.