plans to fail? I have, and I was once that trader! However, did you
know that even though traders who have constructed a plan, which
incorporates their trading stategy (their "edge"), they have a plan
that is likely to fail?
If we look at all traders who participate
in the market: we have one group that fails to plan and therefore plans
to fail; another group whose plan is failed; and a third group who
properly plans and therefore does not fail.
Is it any wonder that the success rate for forex traders is so slim?
Well it doesn't have to be.
Here's a list of reasons why those whose plan is destined for failure fail:
1. They become emotionally attached to their ideas about how the market
should be with minimal or inadequate testing;
2. They fall in love with their back-tested net profit results without
fully understanding other key statistical data;
3. They don't admit they're plan is wrong.
Let's explore each point in a little more detail.
1. Becoming emotionally attached to your ideas without adequate results
Most
new traders when they realize the importance of obtaining a trading
plan and sticking to that plan immediately begin to use the knowledge
they have been taught and haphazardly throw it all together into what
they deem their "trading plan".
When they are questioned on whether they have a trading plan most of these
traders answer with an unequivocal "Yes!".
Most
of these traders are destined for failure because their strategy is
untested. They rely on blind faith to guide them through the trading
jungle to make their untold millions. Would you walk from one length of
the Amazon jungle to the other blind-folded? Of course not! You'll have
to watch out for all the snakes, tarantulas, and other creepy things
that go bump in the night, so why would you approach trading in the
same fashion? I mean all you're really doing is placing the blind-fold
on your capital!
Why do traders do this?
Because it's easy.
That's right... it's easy. They don't need to learn a computer language
to type their system into some piece of software that will take them
the better part of 6 months to a year to learn, and they don't have to
spend any money on buying historical data. Therefore it's easy and it's
cheap and it also conserves time!
So does success meet lazy people like this?
Not
many! However I will admit that it does meet a fortunate few - only
those lucky enough to start their trading during roaring markets where
even a monkey can make money! To repeat again: don't wear the
blind-fold. Your success may be great at the start, but given time and
trades, you'll be the one out of the game - having depleted all your
capital.
So what do you do if you KNOW that your method is untested?
If
you have the time, the money and the learning capacity I would strongly
encourage you to purchase some back-testing software (such as Wealth-Lab
Developer), acquire some forex data,
ask heaps of questions on the Wealth-Lab forum on how to code your
ideas and within 3-6 months you'll be safely coding your own forex
system and testing adequately.
If you do not have the
time, the money nor the learning capacity I would strongly suggest that
you manually write down your system into clearly defined steps that you
MUST follow. Then, after opening a DEMO forex account you would trade
your system according to the rules you have set out. Trading your rules
until about 20 trades have been completed.
After traders obtain
their results from their testing period they unfortunately look at only
one figure and make a rash conclusion about the system based on that
one performance figure, namely, the net profit. This then leads us into
the next problem of why traders plans are failed prior to placing their
first live trade...
2. They fall in love with the net profit result and no longer question it
any further!
The
net profit is only one statistic among thousands, however, to keep
things simple we will look at the top 3 results that you need to make
sure you fully understand.
Here are the other statistical pieces of data that you should look at when
your system has completed its testing period:
I.
How many trades did it have? If you have made a nice profit, but have
only had 3 trades during the testing period you do not have a
sufficient sample space to arrive at any safe conclusions. Can you
imagine what would happen to Neil Armstrong if NASA had only done 3
computations on how they would arrive on the moon??!! If it's not good
for NASA then it's probably not good for you either, however, as NASA
do zillions of computations you would only need to conduct about 20
trades as the bare minimum before you can arrive at any safe
conclusions;
II. What was your money management procedure during
the testing phase? This is by far the most important point, however,
you need to make sure your system is properly working prior to even
embarking on this difficult area (hence the reason why it is a CLOSE
second to the above point). Be sure you fully understand what I am
about to explain (read it several times to absorb it if need be)...
If you test a method whereby you rely on a percentage amount of capital on
a trade you can be biasing your results!
How?
Let us look at the following comparison sheet
where we plot 21 trades with their pip return (we'll assume that each
pip = US$1), and compare the returns against using 10 contracts per
trade, 10% capital per trade, or 2% risk per trade...
Example Trade Sheet
Now
as you can see from the results they can easily be doctored according
to the different type of money management technique you use and what
variable you decide to use it on (i.e. who is to say that we not use 20
contracts per trade, or 20% capital, or 5% risk per trade - all of
these would inflate the net return figures).
It is best when you
trade to stay at a fixed quantity. If you use any results that require
a percentage calculation of the equity balance prior to the trade
quantity being calculated you will BIAS the last trades more than the
trades at the start. Hence, using a fixed quantity throughout the
entire sample is one of the true indications of whether your system is
profitable or not.
III. What was the drawdown? This is the
largest peak to trough distance on your equity curve. In other words,
if you were to enter in on the day the equity curve made a peak, how
much would you have lost if you bailed out at the lowest point? To test
this manually you would obtain an equity curve peak trace how far the
equity curve goes down until it moves higher that the peak you started
from - the lowest point made between these two points will be your
trough figure which you will then subtract from your starting peak
figure. The figure with the largest % loss would be your drawdown.
You
would then need to look at this drawdown figure and determine whether
or not it fits your risk profile. Would you be okay mentally if your
account was down the drawdown % figure? If not, then you're going to
have to re-create another system. As a rule I don't like systems that
generate more than 30% drawdown.
One other statistic that
incorporates drawdown that I like to check to determine whether the
system is profitable or not is the recovery factor. The recovery factor
divides the net profit by the drawdown (without the negative sign). As
an example, if the net profit were $5,659 and the drawdown were -$3,542
dividing the net profit by the drawdown would result in a recovery
factor of 1.597 (get rid of the minus sign). I generally prefer systems
to have this statistic above 3.
So even though we have created
our system that fits our personality and risk tolerance level well
trades can still fail by not heeding the third and final statement...
3. Don't fall in love with the system
Most
traders once they have designed a system cannot believe that their
system is making a loss, or worse yet, a loss greater than the system's
historical drawdown.
So, to combat this they dig their head in
the sand hoping that the problem will go away. Just as trades fall in
love with their position, at their own peril, falling in love with
their system is also to their detriment.
Treat this as a business
with your system as one of your salesmen. If the salesman is costing
more than he is bringing in then you need to fire him and find another
one.
How do you know if your system is no good?
As a rule I
look at the historical drawdown of my system and add 10%. As an
example, if my system had historical drawdown of 20% once the system
reached 20% x 1.1 = 22% I would stop trading this system and move onto
another. And sometimes you can still trade the same system, just with
different variables, or a minor tweak.
Be sure that you fully
understand the implications presented to you in this article. Trading
is a business, therefore conduct it like one, as it is one of the most
difficult endeavors you could ever undertake.
Ryan Sheehy is the author of Currency Secrets.com and Forex Zoo
