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Why Average Forex Traders Need to Highlight Risk

A look at two types of trading strategy, demonstrating the huge difference that sound money management can make in the long term.

The increase in volatility in the forex market over the past few years has been something of a double-edged sword for traders. On one hand, it has increased the potential for profit, but it has also made it a much more risky business, especially for novice traders. This has led to a high ‘churn rate’ among inexperienced traders, with many giving up trading forex altogether due to big losses before they have had the opportunity to develop their skills properly. So why are so many trading strategies failing in the current markets?

One of the most common failures among novice traders is the lack of a cohesive money management strategy. Often, traders will come from other markets, so they have already developed fairly strong technical and fundamental analysis skills, but they might not realise quite how important money management is when trading something as volatile as currencies. You can be a very profitable trader with only average analytical skills, but by the same token, you can have very good analytical and forecasting skills and still make a loss – it’s money management that really makes the difference.

The Secret of Money Management

One of the cornerstones of any money management strategy is to let your profits run while cutting losses short. The idea behind this is to make your profit targets bigger than your your loss thresholds. It sounds simple, but it’s not quite as easy as it sounds.

A recent study carried out by US forex broker FXCM, which used execution desk data to look at profit and loss patterns across all their traders between 2005 and 2008, showed there are a greater number of days in which traders post unusually large losses than similarly large gains. The biggest average gain for a single day was around 130 pips, whereas the biggest average loss for a single day was 180 pips. Although traders were turning a profit on 54% of all trading days, the average trader lost money overall due to big losses on individual days. This suggests that, on average, traders were more often than not successful in predicting price swings, but were often undone by poor money management.

Two Strategies Compared

In order to explain what we mean by letting profits run and cutting losses, let’s look at two hypothetical trading strategies. The first is geared towards making profits on the majority of trades – which necessarily involves allowing loss-making trades to climb back into profitability. This means letting losses run, which exposes you to a big downside risk, but should give you a higher percentage of profitable trades. However, because this strategy also exposes you to the risk of outsize losses, one big loss could cancel out lots of smaller gains – which means that you’re more likely to end up with a net loss at the end of the trading month.

The second strategy is less concerned with making lots of profits, and is aimed squarely at making a few big profits and minimising losses. With this strategy, most of the trades will be likely to make losses, but because the average profit is substantially bigger than the average loss, the big wins cancel out these losses. Effectively, this strategy is focused solely on the bottom line, rather than relatively meaningless statistics such as win ratios. Obviously, it takes a lot more courage to adopt a strategy of this type, as you have to be able to stomach more losses and hold your nerve when in profit, but if employed effectively, it will be more likely to succeed than the first strategy in the long term.

The Bottom Line

Of course, both strategies are risky. With the first strategy, which can be considered medium risk with a medium reward, the profits are a lot more consistent, albeit smaller, and it seems to be a safer bet in the short term. The second strategy can be considered to be high risk with a high reward, with a strong chance that you will lose money for a long while before you see a positive return. However, when you make a big loss using the first strategy, it could wipe out all the small gains that you have made, whereas when you make a big profit from the second strategy, it will wipe out all the small losses that you have made. While both strategies would benefit greatly from sound risk management, over longer time frames, the second strategy will tend to outperform the first.

 

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