The Most Important Formula For Trading FX
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