Archive for June, 2010

The 3 Laws of Successful Trading

June 29, 2010 by · 4 Comments
Filed under: Money Management, Press Release, State Of Mind, Strategies 

(This is an article I wrote for “Your Trading Edge” in the June 2010 issue)

Having had the privilege of speaking to audiences about FX trading worldwide, I have noticed a common question: “What is the best strategy to trade forex?”

Each time I hear the question, I can’t help but smile. After all, that was my biggest question when I first started trading forex. It’s almost always, “Give me the strategy first, and we’ll talk about trading later!”

In this article I hope to shed some light on successful trading, and how we can all get there. Let’s start with the definition of a successful trader. The benchmark of a successful trader is that he must be consistently profitable.

Notice the word ‘consistently’. I’m never impressed when I hear someone is “making 500 per cent in a month”. Don’t get me wrong – these are amazing results; but any trader worth his salt must know that his game plan is to stay consistently profitable. It seems inevitable that the few who make exorbitant returns in one month get washed out the very next month, because they probably took on (and continue to take on) excessive risk.

Remember, you might be able to make 500 per cent a month for a particular month, but if you lose only 100 per cent any month, you are out of the game forever.

The Three Laws

How does one become ‘consistently profitable’ in the forex market? I would like to share my three laws of successful trading. They are not mutually exclusive; rather, they must go hand-in-hand. They are:

  • Strategies
  • Money management
  • State of mind

Strategies

There are four basic strategies for profiting from the forex market: trending, ranging, breakout and news release strategies.

Trending strategy
A trending strategy is employed when the market is clearly in an uptrend or a downtrend. When the market is in an uptrend, go ‘long’. If the market is in a clear downtrend, go ‘short’. This is, by far, the most popular method of banking profits in the forex market. As the saying goes: ‘The trend is your friend until it bends.’

Ranging strategy
A range occurs when the market is trading in a channel – between a floor and a ceiling. The price seems to bounce repeatedly between these two areas, called support and resistance. For this strategy, traders tend to go short near levels of resistance because buying pressure succumbs to selling pressure, hence pushing the price down. Conversely, traders execute buy, or long, orders near areas of support because selling pressure succumbs to buying pressure, which pushes prices up.

Breakout strategy
A breakout strategy is employed when prices finally break out of a trading channel and head either up or down. Momentum is greatest on breakout points; hence traders tend to capitalise on these specific movements by going long once prices break upwards from a trading range, or short once prices break downwards from a trading range.

News release strategy
I know a number of traders who trade exclusively around the news. Two of the most popular news announcements are interest rate changes from the G7 countries and the Non-Farm Payrolls from the United States on the first Friday of every month.

Because there is no telling which way the market is going to react once the news is announced, I do not advocate trading around the news for new traders. Markets tend to be irrational, and this is not the behaviour you want to experience when you have just begun your journey.

Another downside to trading around ‘hot’ news is that brokers have a tendency to widen their pip spread during these times. Spreads can easily widen to 20 pips, regardless of whether you go short or long, during this volatile session. Be mindful of this the next time you feel like trading on a ‘juicy, piece of news.

Money Management

Much can be said around the topic of money management; but I’d like to focus on just one aspect: risk. In the world of retail forex trading many promising traders are still oblivious to one of the biggest pitfalls of trading: the tendency to take on too much risk.

Sometimes traders just do not understand how much risk is too much. The golden rule is never to risk more than one to five per cent of your capital on any trade. In fact, I know many professional traders who consider five per cent to be too much. Some of them never go beyond two per cent.

What does this mean, specifically? If you have a trading account of $US10,000, a two per cent risk means that you will not lose more than $US200 if your stop loss is hit.

If we assume your stop loss is hit, then for your next trade you would begin with $US9,800 capital. It is hard to imagine anyone blowing up his or her account with such tight rules; but the sad fact is that traders are unaware of how they should practice prudent money management.

Here’s an example to drive home the absolute importance of money management. If you start with an account of $US10,000, you would have $US5,000 left if you blew off 50 per cent of your account. The real question is how much you would have to make in order to bring your account back to the break-even level of $US10,000.

The answer, of course, is 100 per cent. In fact, the statistics are not pretty (see figure 1).

We are often reminded: “Amateurs are concerned with how much they can make. Professionals are concerned with how much they will lose.”

State of Mind

State of mind concerns a trader’s thoughts and emotions. It is the component that will present itself as by far the biggest stumbling block to a trader’s success. Four human characteristics – fear, greed, hope and ignorance – will always be a part of every trade.

Imagine you have just completed your ‘apprenticeship’ trading the demo account and you are now ready to trade live. The first opportunity opens up. It’s time to make big bucks. However, when it’s time to execute the trade, you somehow freeze up. Your finger just can’t find the energy to click the mouse. This is fear. You then watch in horror as your trade (which you didn’t take) goes on to register a win!

At your next trade, you double your lot size. This is greed. You double your lot size because you want to win back the money you left at the table by not taking the first trade. As Murphy’s Law would have it, this trade is now heading towards your stop loss! You then do the unthinkable – you remove the stop loss. This is ignorance. You remove your stop loss because you are giving the trade some ‘breathing space’ to reverse and, you hope, register your first win. Sound all too familiar?

I hope (no pun intended) that you now see that all three laws – strategies, money management and state of mind – must come into play for you to achieve any degree of success in trading. In fact, if we assume that the three circles make up 100 per cent of a trader’s success, then they can be divided as follows:

  • Strategies: 15%
  • Money management: 30%
  • State of mind: 55%


Strategies (15%)
Even when your strategies work, it is a fact that they account for only 15 per cent of your success in trading.

Money management (30%)
Money management is twice as important as strategy because if you take on more risk than you are allowed, you put yourself in a position where your account can be badly damaged. Remember, it takes more effort to recover an account that has a significant drawdown.

State of mind (55%)
And state of mind is twice as important as strategy because everything rises and falls on the way you, the trader, execute your plan.

Strategies and money management can be taught. Strategies are what to do. Money management is how much to do. However, state of mind -– thoughts and emotions – is difficult to control. Humans are emotional creatures and money is an emotional topic.

In summary, the three laws – strategies, money management and state of mind – must work in harmony before you can be consistently profitable in the forex market.

(Download the PDF version of the article here)

http://www.fx1academy.com/doc/3_Laws_to_Succesful_Trading.pdf

Get Leverage!

June 14, 2010 by · Leave a Comment
Filed under: Press Release 

(This is an article I wrote for Smart Investor in the June 2010 issue)

What is “Leverage?”

In its purest sense, Leverage allows us to do “more with less.”

In the financial world, the concept of leverage is used by investors to significantly increase the returns on an investment. Leverage is commonly seen as a “double-edged” sword in trading. It has its fans and its adversaries.

Those in its camp love the fact that large amounts of money can be made with “little money down” while those in the opposing camp lament the fact that leverage always causes accounts to “blow-up.” This quickly gives an impression that high leverage is “risky.”

While many traders have heard of the word leverage, few have a clue about what leverage really is, how leverage works, and how it can impact their account. In short, leverage is quite a misunderstood term, especially in the area of Forex Trading. Having said that, let’s delve into the topic a bit more before we draw any conclusions.

Now, leverage involves “borrowing a certain amount of money.” In the world of Forex, that money is usually borrowed from a broker. For instance, when a trader opens up an account with a broker, the amount of leverage provided is either 50:1, 100:1 or 200:1, depending on the broker. Some brokers today even offer leverage of up to 400:1 or 500:1.

Let’s quickly run through some basics to understand the use of leverage a bit more.

When you trade 1 standard lot in Forex, you are trading 100,000 units of the base currency. For example, let’s say that the current price of USD/JPY is 100. This means that 1 USD is equivalent to 100 Japanese Yen at that point of time.

You assess the market and realise that the US dollar is undervalued against the Japanese Yen, which means that you initiate a BUY order in the hope that the price moves up.

Now, to buy 1 standard lot of USD/JPY at the current price of 100, you are actually buying 100,000 units of US Dollars. Most of us do not have that kind of money to initiate the trade! Hence, brokers step in with the perfect solution and offer us the “additional capital” needed to fund the trade.

They do this by introducing “Margin Trading.”

Margin allows a trader to purchase a contract without the need to provide the full value of the contract. Hence, for a $100,000 position (1 lot), on 1% margin, the trader is required to “put down” only $1,000.

The leverage provided on a trade like this is 100:1 (100,000/1,000). Here’s the formula:

So for 1% margin, leverage is 100:1. Hence, a trader can control $100,000 with just a sum of $1,000. For a leverage of 400:1, the trader only needs to “put down” 0.25% margin. This means that a standard lot of $100,000 can be controlled with only $250.

The table below gives us a quick reference on how margin and leverage co-exist as two peas in a pod:

Although high leverage gives the impression that the trade is risky, the “perceived risk” is significantly less when one considers that currency prices usually change by less than 1% during intraday trading. If currencies fluctuated as much as equities, brokers would not be able to provide as much leverage.

What? Now wait a minute.

I thought Forex has high volatility and that it fluctuates more than equities?

Let me explain.

In Forex, the currency movements are so small on an intraday basis that a new term called “pips” had to be introduced. A pip is the smallest movement in a currency price. This could be the second or fourth decimal place of a price, depending on the currency pair. However, these movements are really just fractions of a cent. For example, when a currency pair like the EUR/USD moves 100 pips from 1.5100 to 1.5000, it is just 1 cent (or $0.01) of the exchange rate.

Let’s look at a recent example to drive home the point. On 1st April 2010, the price of EUR/USD was 1.3580. On 1st May 2010, the price of EUR/USD was 1.3380. Consider also that this was during a period where the markets were very volatile because of the problems in Greece.

Now, as volatile as the movements were, it was “only” a movement of 200 pips, or a mere 2 cents. Would you trade a stock that moved just 2 cents in 1 month?

So you see, the reason why brokers can afford to give high leverage in the Forex market is because, intraday movements in the Forex market are minute.

This is why currency transactions must be carried out in big amounts, allowing these minute price movements to be translated into decent profits when magnified through the use of leverage. It is the provision of leverage that allows traders to earn significant profits in the market.

However, leverage can also work against investors. For example, if the currency moves in the opposite direction of what a trader believed would happen, leverage would greatly amplify the potential losses. To avoid such a catastrophe, Forex traders usually implement a strict trading style that includes the use of a “Stop Loss.”

Now that we understand the definition and utilisation of leverage, how do we deal with the fact that leverage “kills” a trader’s account?

In reality, the issue isn’t leverage, it is poor risk management. High leverage only reduces the amount of capital required to initiate a position. Great traders know that they will never risk more than 3% of their capital on any trade. Your job is to employ sound risk management by not risking more than 3% of your capital on any one trade.

As an example, if you start with a capital of USD10,000 then a 3% risk means that you will not lose more than USD300 of your account on that trade. Hence, it really doesn’t matter if you trade with 100:1 leverage or 500:1 leverage. It wouldn’t be any “riskier” if you used a higher leverage provided you used proper risk management.

Proper risk management means planning your entry point, profit target and stop loss before placing the trade. Your lot size is then calculated accordingly so that you never risk more than 3% of your capital on the trade.

The point is that leverage is not the enemy. If you plan your trade so that you are risking a small amount of capital on each trade, very high leverage will not have a negative effect. On the contrary, low leverage can severely hamper a trader’s potential for profit because the trader may not have enough capital to enter a full position and/or multiple positions at the same time. On a 10:1 leverage, a trader would have to put down $10,000 to initiate 1 lot as opposed to just $1,000 had he employed a 100:1 leverage.

In summary, leverage is a good thing. It is there to help you. Leverage is an imperative tool that all successful traders use to grow their account consistently. Now shouldn’t we do the same? To quote Archimedes, 220BC: “Give me a lever long enough and a fulcrum on which to place it, and I shall move the world.

(Download the PDF version of the article here)

http://www.fx1academy.com/doc/Get_Leverage.pdf

CNBC, 04 June 2010

June 10, 2010 by · Leave a Comment
Filed under: CNBC 

“Sweet Spot for US Dollar”