Did you know most aspiring day traders quit within the first two years? And only a small group actually make it to their 3rd year of trading? Of course, this research is not exactly comforting, but the reasons for the lack of success of many traders may surprise you.
The real reasons that frequently decimate trading accounts have nothing to do with the actual trading system. In reality, the more influential factors tend to be related to:
- Poor trade management.
- Poor money management.
- Poor risk management.
- Poor capitalisation.
In this article, we shall learn how to gain consistency and longevity in the trading business by inverting typical "bad habits" retail traders tend to demonstrate.
Adopt Proper Trade Management
"My philosophy is that […] you have to cut losses fast. Letting losses run is the most serious mistake made by most investors" – William O’Neil, Market Wizard.
Most retail traders typically desire high win rates, but they fail to "ride winning trades and cut losing trades". There is tangible evidence that retail traders, with the kind of platforms and access to quality information available nowadays, have developed a strong sense for entries, and they are capable of achieving win rates consistently above 50%. However, they do not let their winning positions run, and instead take quick profits.
The reasons can be many, but at the core is the incapacity to remain emotionally detached from the markets. Retail traders "hate to be wrong" and will take small profits because of this. However, if losses are larger than winners, trading accounts will suffer "death from 1000 papercuts".
The logical solution is to have a solid structure in place with which to manage your trades in a logical and consistent manner. Simple tools that can help with managing trades successfully are:
- Peak/trough analysis.
- Price behaviour.
AUDNZD daily chart – Pepperstone MT4.
In the chart above, we have hypothesised a breakout entry (blue line) and we have highlighted potential resistance points above entry. For the ill-prepared trader, these resistance points are "reasons to cut the trade", which may be premature, and may not offer a successful reward compared to the risk outlay.
AUDNZD 1H chart – Pepperstone MT4.
In the chart above, we have used simple peak/trough analysis alongside prior swing levels from the daily chart, to assist with our trade management. As long as price continued to print higher lows on the shorter-term time-frame (in line with our daily bias), we keep the trade live. When we see decisive resistance (triple top) at a key level, we observe the lows and trail our stop aggressively.
AUDNZD 1H chart – Pepperstone MT4.
Without a consistent structure for managing your trades, it will be a struggle to keep your emotions at bay and to cut losses in a logical and consistent manner.
Adopt Proper Risk Management
"My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10% risks on a trade when they should be taking 1 to 2% risks" – Bruce Kovner, Market Wizard.
Most retail traders underestimate the likelihood of facing an extended losing streak. We have recently stated the "loss aversion" mentality that retail traders typically demonstrate, which forces them to take miniscule profits and hold onto losses.
While it’s true that nobody likes to lose, we must accept losses as the cost of doing business. Sometimes the market type changes and opportunities are scarce. Other times, we can get unseated by the odd headline, tweet, or unexpected data print. The bottom line is that we must be trading at a size that allows for multiple hits, without inflicting heavy damage on our trading account.
Below, we have used a simple equation to calculate the probability of consecutive losses.
Potential consecutive loss number = (loss rate^consecutive loss number) * number of trades per month.
For example, how many times could we experience five consecutive losses if we have a 50% win rate and trade on average 50 times per month? There is (50%^5)*50 = 2 occurrences per month.
Source: Propietary Calculations
Source: Proprietary Illustration
Consecutive losses create a drawdown. Up to a 10% drawdown, recovery can happen relatively quickly as the drawdown percentage is roughly equal to the profit required to take the account back to its most recent peak. As a rule of thumb, it’s best not to allow your account to sustain a drawdown beyond 20% because chances of recovery start dropping sharply.
Making 25% in a trading year is a viable objective, using proper money management practices. But when is the last time you made 40% in a year? Or 66%? How many fund managers actually make those kinds of returns?
The list above illustrates the returns that professional currency managers have made. Professional money management is all about consistent returns, not home runs. It’s about limiting the downside, not swinging for 100% returns per year. Keep this in mind the next time you want to bet the farm on a trade!
Risk 0.5% to 1% on each trade. You will survive longer, gain more experience, and ultimately augment the odds of achieving long-term success in the business. (You can use Smart trader tools for this purpose.)
Adopt Proper Money Management
"I have two basic rules about winning in trading as well as in life: if you don’t bet, you can’t win, and if you lose all your chips, you can’t bet." – Larry Hite, Market Wizard.
Connected to proper risk management is the concept of money management. Most retail traders typically use too much leverage. It is true, of course, that the high amount of leverage available to Forex traders makes it possible to trade small, since margin requirements are minimal. Forex may be one of the best markets for learning how to trade, precisely because of the low costs. However, leverage is a double-edged sword and most retail traders fail to properly grasp this concept, inevitably adopting position sizes that are far too large for their account balance.
Why do traders fall into the trap of overleveraging their account? There can be many reasons, but they are usually connected to a gambling mindset, to over-trading (thus having too many single positions in place at one time), or just for the rush of adrenaline that "betting" gives some people.
The bottom line is that the more a trader leverages his account, the less mental leverage he will have. The more money is on the table, the more attached to the bet (and hence, the more emotional) the trader will be. This is all counterproductive, of course.
Keep your trading size under control, and use leverage effectively. Don’t push your risk limits.
For example, let’s imagine two traders who both want to make money trading.
- Bob has an AUD 2.000 account, does not like to gamble, and prefers a conservative, yet consistent equity curve.
- Ian has an AUD 2.000 account, views the markets more like a casino than an actual profession, and wants to swing for the fences.
Pepperstone allows traders to use up to 500:1 leverage on their accounts. This means, in practical terms, that Pepperstone allows traders to control up to 500.000 AUD with AUD 1000. Leverage is connected to the margin requirements necessary to open and maintain positions. To calculate the margin requirement needed to open a trade, use the following formula:
(Market quote * volume) / leverage = $margin required
For example, Ian wants to open 0.1 (10,000 base currency) lots of EURUSD at the current market quote of 1.0500 and with a leverage level of 1:500. (1.0500 * 10,000) / 500 = $21. As you can see from this example, you only need at least $21 free margin at 1:500 leverage to open the trade. This shows you the power of the leverage offered by Pepperstone. If you choose 1:50 leverage (or no leverage), you would need $210 free margin instead of $21 to open the same trade!
Ian does the math and wants to use 25% of his account for margin, and 75% of his account to massage the ebb and flow of his trades. He opens a 250.000 position on EURUSD using $525 of his account and feels confident he’ll survive the trade and make a lot of money, because with his remaining account ($1475) he can withstand 59 pips of adverse excursion against his trade before receiving a margin call.
"Is it really possible that the market can’t give me at least 5-10 pips of profit before moving against me?" Ian thinks to himself. Even 5 pips would be $125, which represents a 6.25% gain on his account. Not bad for one trade!
Ian is focused on the upside of leverage, the money it allows you to control. What Ian is missing is that his focus is on the money and there is no focus whatsoever on limiting the downside or thinking about black swan events. He is risking his whole account on one trade (since his stop loss is essentially a margin call) and is "hoping" to get away with a scalp. There is no longevity in this mindset.
Bob understands the concept of leverage very well and doesn’t care at all about "how much" he can control. Instead, Bob knows that he needs to take into consideration the pip value of his trades and make sure that he trades position sizes that are 0.5% to 1% of his account. This way, he can establish risk limits each week (say 5%), which allow him to take 5-10 trades each week in a safe manner.
Bob wants to sell EURUSD. He knows that 1% of his account is $20. That’s what he is going to risk on this trade. He’s looking to make at least $20 (1:1 risk reward or better). Based on his technical analysis, Bob decides his trade requires a 100 pip stop loss. So, what position size will Bob need to use, so that 100 pips worth of adverse excursion equates to his $20 at risk?
Size = risk/(pips to stop loss*pip value per 10K)*10.000
Size = $20/(100*$1)*10.000 = 2000 = 0.02 lots
Despite his small account size, thanks to 500:1 leverage, Bob can correctly size his positions and keep his risk limits under control. The risk of Bob losing his entire account is negligible.
Be Well Capitalised
"I’m only rich because I know when I’m wrong…I basically have survived by recognising my mistakes." – George Soros, Market Wizard.
The final pitfall most retail traders succumb to is capitalisation. Along with the misuse of leverage, capitalisation is another hot topic. Most aspiring traders approach Forex trading with large aspirations and small account balances. Inevitably, they end up trading position sizes far outside their capacity (overleveraging the account).
But that’s not the only issue with poor capitalisation. Especially for systematic strategies, it’s useful to cast a wider net and have a watchlist made up of currencies, commodities, bullion, indices, and bonds. There aren’t always decent trends to be caught in one market, so casting a wider net makes sense.
However, without proper capitalisation, traders risk spreading themselves too thin, not being able to use adequate position sizes, or opening too many trades (even if uncorrelated) and not having the margin available to sustain even a small drawdown.
Over to You
"Invert, always invert" – Charlie Munger.
Retail traders, as a group, suffer from certain bad habits. In order to achieve consistency and longevity in trading, invert their bad habits. Cut losses quickly. Define your risk correctly. Do not hold onto losing trades, hoping they will reverse. Ride winning trades until they show signs of exhaustion. Use leverage wisely. Make sure your account can "weather the storm", so to speak.