Four Forex Questions for the New Year

Boris Schlossberg

1. How many times will I trade?

As I noted recently this is perhaps the least asked yet the most important question you can answer. The frequency of your trades will determine the amount of risk you can assume. This is not a philosophical discussion but a pure function of statistics and you ignore it at your own risk. The back of the envelope formula I use is to reduce size by 50bp for every 100 trades I take. If my basis is 250bp of risk @ 100 trades I reduce it all the way down to 25bp of risk @ 1000 trades.

Final note: Five adds of the same currency pair at your initial risk level is NOT one trade. It’s five distinct trades. Be honest with yourself to recognize when you do that.

2. What spread will I pay?

If you are paying more than 2 points spread on EUR/USD you are a moron. (So much for my holiday cheer :) Seriously, in an age when most platforms allow you access to 1 -- 2 pip spreads across most major currency pairs paying anything more than that is just sheer idiocy especially if you are trading intra-day.

The spread that really interests me however is the one you will pay on your stop. The smaller the stop the higher the chance that you will lose. A pair can cross the same 10 point range 10 times during the day stopping you out for -100 points before finally making you that 20 pips you are seeking. The key is to make your stop wide enough as to avoid unnecessary exits yet tight enough so you can recoup it in no more than 2 days of trading. My personal favorite for intra-day trading is a 50 point stop

3. Will I trade high probability or high profit?

Remember this. No matter how much you beg. No matter how much pray. No matter how good a boy or a girl you have been, the trading gods will never ever allow to make a high profit trade with favorable odds. If you want to make 2 points for every 1 point of risk consider yourself lucky if you lose only 6 out of 10 times. If you want to win 3 out of 4 times prepare to risk 2 points for every 1 point of profit that you seek. In trading as in life the sweet spot is usually in the middle so I try to keep the odds as close to 1:1 as possible and strive for a better than 60-40% edge.

4. What’s my fail-proof checklist?

If you want even a modicum chance of success in trading you must assume you will fail. To prevent failure from becoming a blowout you need a checklist. Here is mine.

  • Always attach a stop
  • Never add or double down
  • After three losses in a row walk away from the screen for the rest of the day

What’s yours?

Happy Holidays to all across the world. May we all enjoy peace in 2012.

The Most Important Formula For Trading FX

Boris Schlossberg

The more you trade the more you lose. That thought struck me like a thunderbolt as I jumped out of my hotel bed with a jolt. We were in balmy Bahamas getting ready for K’s wedding but trading obsessions never rest so I grabbed my Ipad, trudged down to the coffee shop and started furiously typing notes to myself.

The more you trade the more you lose is not an opinion but a statistical fact. If you are trading a setup with a 60-40% edge your chance of of hitting 5 losers in a row is 1 out of 100 (just multiply .4X.4X.4X.4X.4) That means for every 100 trades you make you must expect a negative run of at least 5 consecutive losers. For most of us in FX who daytrade furiously, one hundred trades can be as short as a week’s or a month’s worth of work.

Don’t confuse high-frequency trading done by machines with the short term scalping done by individual traders. High frequency trades in FX and other markets are mostly based on temporary mispricing and front running algorithms. They exploit the weakness in communications technologies and generally do no market analysis whatsoever. Their expectancy rates are closer to 99% because they cheat and that’s how they are able to make thousands of trades per day without incurring many losses.

Unfortunately as individual traders we don’t have the luxury of cheating and must rely on our wits and market probabilities to achieve success. That’s why its so important to understand to understand this formula. Losing is a very natural part of trading, especially if you do hundreds or thousands of trades per year and you shouldn’t despair or abandon your strategy if you hit a rough patch. Its not your setup, its the law of large numbers.

After you become relatively comfortable and confident in your trading approach, the single most important question you need to ask is -- how many trades do I expect to make in a year? Assuming your strategy has 60-40 edge then you should follow these general guidelines. If you are going to trade 100 times or less per year than you can risk up 250 basis point of your account on any one trade ($250 on a $10,000 account). For every 100 trades you expect to make you should cut you risk by 50bp. The following table by no means a foolproof method for winning but it is a pretty good guideline of how you should trade if you want to have a chance at succeeding in this game.

@100 trades max risk 250bp

@200 trades max risk 200bp

@500 trades max risk 50bp

@1000 trades max risk 25bp or less

Why You Should Love The Whipsaw Trade

Boris Schlossberg

Do you know what most traders hate the most? It is not losing money -- everyone understands that losses are part of the game. What traders hate the most is getting whipsawed. Go long, get stopped. Flip the position, go short and watch in horror as price retraces to your original entry and stops you out again. If you just held on to your initial long you would have been back to break even. Now you are double negative for the day!

If you day trade FX you’ve had this happened to you many times, and I bet that nothing has made you more annoyed than the whipsaw trade. Yet here is the truth of the matter. If you ever want to succeed in trading you must learn not only to accept the whipsaw but to actually love it.

Why should you love the whipsaw trade? It’s like death by a thousand cuts. Exactly! Think about it for a minute. What are your chances of dying from a few superficial scrapes? None. On the other hand you can bleed out from one large wound in matter of minutes. Your account is very similar to the human body. It can absorb a lot of small stops, but it can’t recover from one single double-down-every-50-pips-until-I run-out-of-margin trade.

There is nothing more tempting than pulling a stop after being whipsawed a few times by the market, but as I have learned the hard way, this the absolute worst thing to do. Here are some simple statistics to remember. If you are running a strategy that has a 60%-40% edge the normal chance of hitting six losses in a row is only 41 basis points or 0.41%. That may seem ridiculously small, but if you trade every day, this will occur with regularity one out of every 200 trading days. (If you trade more actively like I do then the probability increases to one in 50 days).

In short if you day trade, you are going to be wrong. And you are going to be wrong a lot. That’s why its crucial to love the whipsaw trade. It’s the best risk control tool at your disposal, because it is keeping you alive until the market turns your way.

Kathy is Getting Married – Returning Jan 9th

forex blog Kathy Lien

First I want to apologize for being MIA for the past few weeks. Didn’t realize wedding planning would be so tough! But -- all is finally done and I am happy to say that I will be getting married on Dec 12th and will then be off for a nice long honeymoon. I will back in the office on Jan 9th and one of my New Year resolutions will be to blog more! I promise!!! In the meantime, I want to wish all of you a wonderful holiday and a happy New Year. See you in 2012!

Trader’s Mind Tricks

Boris Schlossberg

Let’s say I told you that you could make 25,000 dollars by risking 25,000 dollars. Would you take the bet? Probably not. Like most people you would want to be able to make at least 50,000 dollars on 25,000 dollars worth of risk. And therein lies the problem.

Psychological studies have shown that human beings feel the pain of loss twice as intensely as the joy of winning. In short you would be much more upset about losing 10,000 dollars than be happy about earning the same 10,000 dollars. Out of that quirk of human nature traders developed the classic 2-1 risk to reward rule looking to make $2 of profit for every $1 of risk exposed to the market.

On the surface the 2-1 risk reward system sounds so attractive. Just be right 50% of the time and you make money! Heck you can even be wrong 6 out 10 times and still be profitable! How hard can that be? After all, flipping a coin will give you a 50% chance of success.

This is precisely the type of thinking that gets novice traders in trouble. First of all, disabuse yourself of the notion that on any given trade you have 50-50 chance of success. It that were true we would all be billionaires by now. As my friend Tom Sossnoff used to say when he ran ThinkorSwim brokerage business, the actual odds on any trade are more like 25% -- 75% against the trader. The reason is because you are not trading against some predictable number generating machine but against many wily human beings whose primary function is to trick you into making the wrong move. Speculative trading is the art of separating suckerx from their money and as some wise old man once said if you are sitting at a table and don’t know who the sucker is, you are it.

Let me explain in detail why 2:1 risk reward strategy is so difficult to implement successfully, especially on a day trading basis. Let’s say you are trading a strategy that risks 10 pips of loss to gain 20 pips of profit. Since prices very rarely move in straight lines here is what’s going to open. You enter the trade and get stopped out. You enter again and get stopped again. On the third time the trade may go 10 points in the money but will then pause, retrace and stop you out again. On the fourth time you may finally get that clean 20 point run but even if the trade goes to profit you will be net negative 10 points for the day because of all the back and fourth slippage. The tighter the stop the greater the chance of stop out. That’s just the nature of the game and that’s why 2:1 risk reward strategies rarely make it in speculative day trading markets like FX. They may work on longer term horizons, but since I’ve never held a trade for more than 72 hours in my life I wouldn’t know.

What I do know is that there is no “perfect” risk reward strategy for short term trading, but over the years I’ve come up with some guidelines that seem to work relatively well. First and foremost I never make my stops less than 50 points. This is by no means a definitive rule, but after tens of thousands of trades I’ve found that 50 points is the just the right balance between avoiding the repetitive stop-losses and getting out when you are clearly wrong.

As to my limits I find that setting your take profits at 70% of amount risked is a reasonable compromise between fear and greed. This approach requires that your strategy be right 65% of the time but by flipping the risk reward ratio to a slightly negative skew it becomes a lot easier to achieve that goal.

Trading is a wonderful activity, but on the the short term horizon where we ply our craft everyday it can be a little like quantum physics where the normal laws of Newton do not apply. What seems logical is actually foolhardy and what is foolhardy is actually effective. So beware of these mind tricks next time you do a day trade and remember that taking less and risking more may not be psychologically palatable but could be financially rewarding.