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The Principles of Successful Forex Trading

Why do successful forex traders keep making money year after year, while the inexperienced forex traders lose everything within the first few months? What is it that most beginner forex traders get wrong? How do successful forex traders traders know what’s right?

I am often asked on a weekly basis how to succeed in forex trading. I have been asked these questions so many times, that I finally decided to write it all out. CandleForex will give you straightforward and easy to follow advice on how to become a better trader.

Unlike most trading advice that is given by experts in their field, I am going to keep this free of jargon wherever possible. If for some reason jargon is used, you will see an explanation in the footer. I am going to describe and explain various problems in a detailed way. You will read about the mistakes that prevent forex traders from making a profit. You will also learn the basic principles that took many successful forex traders years and many thousands of dollars to discover. All facts in this report are based on years of observation and can be easily verified.

Have you ever felt like you have finally learned how to predict forex market moves after a winning trade? And then only a few days later you have a devastating loss?

Now imagine the feelings of a forex trader who spends several years studying price movements on charts, studying candlestick patterns and memorizing these patterns, buying expensive technical indicators and learning how to use and apply these indicators, following various expert advice (good and bad), and paying to attending trading seminars. However, this forex trader keeps losing money until all their savings are gone. He may then raise more funds and loses everything all over again, while wondering contrary to all the experts promises; he can’t turn forex trading into a profitable business. Forex trading is just as understandable, predictable and profitable as any other business.

Now imagine that after you spent years invested in forex trading you still don’t understand how markets work. How frustrating would that be to you?

Or even worse, what if you were driven by emotions and you lose control of your trading with the result of all your savings disappearing? Do you have an emergency backup plan to protect yourself?

How quickly do you think you could recover from heavy losses in forex trading if at all?

Beginners but also veteran traders tend to ignore or forget about taking the needed steps to protect their trading capital against these types of calamities until it actually happens. By then it is too late and the damage is done.

Not To Me

After checking some statistics we found that 9 out of 10 traders will experience some type of loss or losses that will end up costing them several thousand to several million dollars.

Remember this does not include funds spent on manuals, training fees, forex trading seminars or months of painstakingly analyzing charts. It also does not include the money spent on computers and extra monitors for trading forex.

Losses rendered from poor forex trading practices differ for everyone. However, whatever those losses may be, they are always too high for the forex trader involved. As a general rule, people lose all their disposable money. However some forex traders go even further and get dragged into debt, because they used a credit card or took out a loan to trade forex.

Backing up the claims:

95% of traders lose money (Source: Noble DraKoln, the author of “Winning the Trading Game: Why 95% of Traders Lose and What You Must Do To Win)

Why Day Traders lose money (Source: John Forman, The Essentials of Trading)

90% traders lose money, only 10% don’t (Source: Courtney Smith, How to Make a Living Trading Foreign Exchange)

What Do These Numbers Mean for You?

Clearly most people underestimate the risks of forex trading. Most of the time people are simply misled by advertising from various brokers and Referring Agents (Introducing Broker). As a general rule, your broker does not care about your long-term success because the brokers goal is to quickly earn back the time and money invested in attracting the new customer(s). This why brokers want you to start trading as quickly as possible, so that your broker can earn the spread on every trade you make. To achieve their goals, brokers provide traders that are just starting out with the minimum information that is just barely sufficient to make. Then brokers let them fly blind in the market. These unscrupulous practices have drawn the attention of various governmental agencies supervising and monitoring securities trading, like the CTFC and the NFA. Unfortunately little success has been achieved in stopping these practices. This is particularly true if you are based in the USA and chose an offshore broker, or use a forex broker that is not NFA registered.

The sad truth is that most so called trading experts sell trading methods that don’t work. Of course, these methods are presented as highly profitable. A potential customer of these trading methods is shown the few occasions when an indicator (or some other method) happened to predict a good forex trading opportunity. What is left out of the picture are all the instances when the method led to non-profitable trades. Sometimes even basic money management is disregarded.

Furthermore, so called trading experts (or teachers if you prefer) avoid selling their trading strategies as a set of formally defined rules to enter the market. Their main argument is that their indicators must be applied differently in different scenarios. In other words they change the rules all the time to “fit” the scenario. Consider there is multiple possible scenarios to trade every day, so obviously it’s a kind of bending the rules continually. You cannot trade when the rules are continually changing, you will just be throwing money down the drain. These teachers claim that no algorithm based system can substitute for human intellect (which is wrong). This kind of reasoning is extremely convenient. When the advertised trading method brings bad results they always blame the trader not their trading system. That is because in the sellers opinion the results depends on the forex trader’s subjective determinations (it’s different for everyone) and it is impossible to prove that the trading method that doesn’t work. So you end up being blamed for your losses.

What’s most annoying about this situation is that most of these losses and costs (like your brokers spread) could have been completely avoided or greatly reduced easily and cheaply with a little chart analysis and proactive verification (like visually checking the chart and or indicator(s). An example of proactive verification would be using CandleForex “Rule of Five”).

Another equally annoying fact is that it is really possible to define trading rules and put these rules into mathematics, and then code these rules into a program that will trade for you. The most common of these coded rules, called “expert advisors” end up being used in MetaTrader 4. Sometimes a person prefers to trade manually and they code these rules into an indicator (or multiple indicators sometimes).

Why Are New Traders Particularly Vulnerable

Forex markets (as well as other markets) are becoming increasingly efficient and it is possible to trade faster. To survive in this highly volatile environment, unconventional tools and methods are sometimes called for. However, in defiance of common sense novice traders don’t even bother try to use the latest market analysis tools! Instead, they try to use trading methods that worked quite well 20 years ago but are totally useless today.

Institutional forex players and market makers, on the other hand, have state-of-the-art trading methods and the required computer technology. Trading forex is not a zero sum game but the odds are stacked against novice traders. In this game, for lack of a better description, novice forex traders invariably fall prey to the more advanced players who have more capital or do stop hunting.

Money Spent Just to Discover That a System Doesn’t Work

I know of several people that purchased a set of indicators from various so called “forex teachers”. The methods consisted of waiting until all the indicators showed a when to enter the market. Naturally such trading opportunities do not come up every day.

You would think that common sense should have told these people to paper trade (also called demo trading) their method(s) first, to see how well they would work in the real market. However emotions and the so called forex expert’s convincing arguments won over. These customers blindly took several trades that emptied their trading accounts.

This is why I keep telling people over and over again, to demo trade any method before going live. I always suggest to backtest the method first and to forward test the method too, before going live. Sure some people might think this is a waste of time, but it saves you a lot of time in the future, as well as money.

Backtesting involves testing the method over some previous timeframe. I always suggest not to bother backtesting more than one year. If the method is profitable then move to forward testing, otherwise dump the method.

My logic is simple: what did not work in the past probably won’t work in the future.

Forward testing involves opening a demo account (paper trading) and trading the method with play money, after backtesting of course. I suggest a minimum of two months, ideally three month. While this may seem initially a long time it has always proven to save forex accounts from blowing up if a method does not work.

Live trading is the final step after you feel the method has proven itself.

Some people do not believe in backtesting, and just dive straight into forward testing on a demo account. This is particularly true of people that trade with indicators only, and that is ok, it’s your decision. Just remember not to fool yourself by only forward testing for a short period of time (less than 6 weeks) and calling it “profitable”.

To summarize If these traders had spent time on a back-testing program (Metatrader 4 is one, and its free) and forward testing on a demo account, they could have saved hundreds if not thousands of dollars and time.

How Slow Reactions Cost Money

As you know news trading is a system based on significant economic news releases. My strategy correctly indicated the entry directions. Back then I was not using automated trading and I had to manually adjust the stop-loss as soon as the market started moving in my favor. The broker I was using at the time did not support trailing stops, so manual adjustment was the only way to trade with my method. And no I am not going to name that broker.

Anyway as soon as the profit reached the required value I had set, I started adjusting the stop loss. Unfortunately it took me too long (about 5 seconds) and a potentially profitable trade was closed out with a loss. You see the forex market gets highly volatile following economic news releases, so the 5 seconds or so for manual correction was way too long. If I had managed to adjust the stop within 2 seconds, I would have made 100 pips ($1000 for the currency pair I was trading). As you can imagine I was very annoyed.

This is why I moved to automated order execution for my forex trading as it allows reduced reaction time. It will take your computer less than 1 second to place trades and or to modify an order. I use MetaTrader 4, but other people prefer NinjaTrader or TradeStation.

At the time it was very expensive and hard to find a programmer that could code my news trading strategy, but I learned my expensive lesson.

NOTE: It was really possible to trade news manually but not nowadays.

A Few Consecutive Losing Trades Made a Forex Trader Give Up on a Proven Trading Method

I know of a forex trader that had a forex trading system had been tested before and had proven itself as reliable and profitable. Of course this trading system was backtested against historical data and forward tested as well. It had an acceptable win loss ratio in his opinion.

However, in live trading the system generated slightly more loosing trades than was shown in the backtests (and forward tests). If memory serves me well, I think the trading method had a win loss ratio of 3:1 and then in live trading it was 2.57:1 and because of that, this person decided to dump that method.

For people that do not know what a Win/Loss ratio is, here is an example, if you made 50 trades and of them 36 were profitable and 14 were losers, your win/loss ratio would be 2.57:1. Your probability of success would be about 72%

This person found it psychologically difficult to use the method that seemed to have dropped in profitability in live testing even though this was expected. Forward testing results and live results *always* differ, but the difference should not be drastic for a well designed system. As long as the system makes more winners then losers, you end up in profit.

When I asked why he didn’t continue with such a small difference (3 – 2.57 is 0.43), he said that the reason was quite simple: He wanted the forward tests to exactly match the backtest results.

The unwillingness to factor in a small but expected variation meant he ended up chasing multiple systems in a row only to keep dumping them after they never matched the forward tests. Since forward tests never exactly match backtests he wasted months of time. After a few months he finally “got it” and revisited the systems that varied by a small margin. He did however miss months of profitable trading.

I always suggest around 3:1 win:loss ratio for people that trade with less than $2000 or so, but ultimately what is acceptable is down to your type of trading.

Depending on how you trade (scalper, day trade, swing trade etc), what is an acceptable Win:Loss ratio will differ. Only you can decide what ratio is acceptable; just don’t expect a ridiculous win loss ratio (like 9:1) and dump trading systems because they don’t have a high enough win:loss ratio (less than 9:1). If you do, I can promise you will lose months and possibly years of lost trading opportunities (and time). In my professional opinion, anything better than 2.5:1 win:loss ratio is good for a scalper, a day trader or an automated trading program (like an expert advisor for Metatrader 4). However again like I said it’s a personal choice.

Protect Yourself from Common Mistakes:

While it’s impossible to plan for everything, a little analysis (e.g. charts) and a few simple rules will help you avoid or greatly reduce your trading losses. Remember if you fail to plan, you plan to fail.

In my experience I have found that most novice and even experienced traders are NOT conducting any type of market analysis, which leaves them completely vulnerable to the situations you just read about. This is mainly for five reasons:

(1) Traders don’t understand the importance of verifying trading systems before going live (backtesting and forward testing).

(2) Traders use outdated market analysis techniques instead of the latest and most efficient approaches.

(3) Even if forex traders do have a good trading method, they can’t use it the right way (eg correct money management)

(4) These traders depend on profits from a single strategy on a single forex pair (eg only trading the EUR/USD)

(5) These traders do not have multiple strategy for multiple scenarios. For example a trading strategy for trending markets, and a trading strategy for range bound markets, and a strategy for news trading etc

While there are many tasks that need to be performed in order to succeed in trading, I’m going to share with you the few that I deem the most important for protecting your trading capital and creating the most favorable conditions for a profitable and consistent strategy.

Step#1: Do Not Trust Any Unproven Trading Ideas

I have never figured out why people blindly trust the so called trading gurus, maybe its greed. Most forex trading gurus are nothing more than frauds. However, my main point is that you should not trust anybody on their word alone, not even yourself. You are the only person responsible for your trading failures and successes. If you fail, the only person you should blame is yourself (for not testing the strategy). If you have a trading idea you must backtest and forward test it. All assumptions and untested ideas cost time and waste money. Remember bullshit does not work at the dinner table.

Step #2: Learn From Those Who Really Know How to Make Money While Trading

Study the practices of traders who make money out of the forex markets year after year. Finding such people is a major challenge however. Most forex gurus you may meet will tell you that they are extremely successful and that they teach trading just for the fun of it or out of pure generosity. I am sorry to tell you but in 90% of these cases all their success stories will be lies.

A forex trader is considered successful if he (or she) has been trading profitably for two or more years. Keep in mind as well that usually a forex trader cannot teach, and that a (forex) teacher cannot trade. It is extremely rare to find an unbiased person who is both a forex trader AND a forex teacher.

Don’t believe me? Well listen or read Bloomberg TV or any other financial TV station, and what do you notice?

(a) All of the analysis guys do just that: commentary and analysis of the instrument……usually AFTER the fact

(b) You don’t see forex traders actually teaching, they are too busy making money.

(c) You don’t see teachers because they are usually in seminars…hosted by guess who…..yes brokers!

I can almost guarantee you if you pick a so called forex teacher, and throw him into a place where he can place trades (while you watch him), he will margin out the account.

I only trust statistics coming from unbiased sources. For my analysis I rely on my candlestick charts, my indicators and expert advisors alone. I admit anybody could be making money for a few years due to sheer luck. That’s why you need to single out those traders who have been making steady profits for more than 2 years if you wanted to consider learning from them.

Most successful forex traders automate most of their trading to be faster than everybody else. Also, they always diversify their trading across multiple forex pairs.

If you analyze the trends in the forex trading industry, you will see that most of the trading solutions out there have been created for institutional traders and cost thousands of dollars. The high demand for automated trading is only natural because they understand that the best trading opportunities can’t last long. Mere seconds separate winners from losers.

Today’s markets (not just forex) respond well to various strategies and high frequency trading. These methods, however, call for reliable trading systems and dependable software to use them. Some examples of dependable software would be MetaTrader 4, MetaTrader 5, NinjaTrader and TradeStation.

I must point out once that the primitive systems that most novice traders get a hold of ceased to work long ago. Most of the systems novices use tend to be some variant of a Moving Average and MACD or something like that. Nowadays, markets require brand new methods that in general you will not find in published books.

Step #3: Run Multiple Tests of Your Trading System under Various Conditions

I am not going to deny the benefits of demo trading, but I prefer backtesting first and then forward testing. Backtesting is fast provided you have a reasonably fast computer. Backtesting is also an objective way to test a trading method quickly in different situations without letting emotions interfere with your judgment. When testing your trading idea in real time on a demo account, it’s impossible to ensure that your tests are error free and extensive enough to be statistically reliable. I’ve met few people who would be prepared to paper trade a strategy for at least 3 months before switching to real world trading. As a result, their opinion about the strategy’s workability and performance are wrong.

Backtesting allows the trying of a method against different historical data across different forex pairs. It also ensures that the results are unbiased and consistent. Of course, there are a number of backtesting rules but I will discuss these later.

Invest some time and effort to backtest and forward testing yourself and you’ll find out if the trading idea is worth anything. I can assure you that you’ll reject 90% of the systems that you thought were a sure thing!

Step #4: Don’t Miss the Benefits of Optimization for Fear of Curve Fitting

Most people get scared of optimization because in most cases they apply it incorrectly, or don’t know how to apply it. Most people optimize their trading systems to find the best parameters. However, optimization must be approached in a particular manner.

It will take a long time to explain optimization, so I will give you a few examples instead.

How do you create a new trading method? You could visually scan charts for patterns and check how well those patterns work in various situations with various indicators. Such eyeball tests are nothing less than pure speculation, that is not optimization.

Why? Because for example, you will use a moving average with the length of 20 and won’t use a moving average with the length of 50. Why? Because you can visually see that the 50 moving average can’t predict market moves as precisely as the 20 moving average. In that above examples, you have just visually optimized your strategy. The danger of such optimization though is that the chosen value of 20 can be completely random and have no rational foundation. The reverse is true as well, on a high timeframe.

Why should you optimize? Optimization is important for solving two tasks.

(1) Eyeballing data for the best parameters is too tedious and time-consuming. Moreover, you might simply never manage to find those best parameters. Let the computer do the job and it will do it much faster than you would. For example, with the help of the genetic optimization in MetaTrader 4 I can test hundreds of settings with different parameters and find out what works and what doesn’t. Visual analysis of the same set of indicators would take centuries.

(2) Optimization ensures that the “discovered” optimized parameters aren’t random or over sensitive to changes. Just backtest the optimized settings and you’ll see how robust your strategy is. If even minor changes affect the strategy’s performance and there are no logical explanations for each value, you’re simply using a curve fitted ( over-optimized) system that might look pretty when tested, but will result in disastrous losses in live trading.

Step #5: Trade Several Forex Pairs to Ensure Consistent Profits

According to experts, it is vital to trade several uncorrelated forex pairs. Forex pair diversification compensates for periods when it is unfavorable to trade a particular currency while steadily increasing the overall size of your trading account. It is obvious, that even the most consistent strategy will run into periods of losses. This is normal for the dynamics of forex trading. Some forex traders find this phenomenon extremely hard to deal with. These traders feel like the system is no longer working because the market has changed. These assumptions more often than not override logic and common sense, which leads to poor trading decisions.

To eliminate or at least minimize this phenomenon, several strategies must be traded in uncorrelated forex pairs. This way you will ensure a steadier capital growth and reduce losses during unfavorable trading periods. Profits from trading one of the forex pairs will compensate for the money lost on another forex pair. The result will be a modest but steady growth which is the most important thing in trading. Today, creating such a portfolio isn’t a difficult task. Portfolio level backtesting is now available for a reasonable price. CandleForex offers such a service. Just a few years ago only large companies with enormous budgets could afford to do portfolio backtesting.

Step #6: Automate Your Trading Method to Avoid Errors

It is known fact that a single signal is not enough to enter the market. The latest trading methods call for the best possible entry price. This is especially true for high frequency trading. Human reaction isn’t quick enough to respond to price changes within microseconds. Currency prices can change several pips in less than a second which can result in a smaller profit or even in a loss.

MetaTrader and other software makes automated trading perfectly feasible. All you need to do is code your strategy and enable auto-trading. Of course, the forex trader still must monitor the automated strategy execution and interfere should the situation require. It is the same thing as the pilot of an auto-piloted plane has to do.

There is another important reason to automate your forex trading. There’s no point in staring at your computer screen 8 hours a day in order not to miss a good trading opportunity. What if you’re monitoring a portfolio consisting of dozens or hundreds of forex pairs at a market maker or a bank?

Instead of wasting your time in that way you could use it to do research and improve your trading methods or to find more methods. Let the computer do all the routine work. This approach will make trading exciting and far less tedious which is particularly important if you want to be a full time trader.

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