In the high leverage game
of retail forex day trading, there are certain practices that, if used
regularly, are likely to lose a trader all he has. There are five common
mistakes that day traders often make in an attempt to ramp up returns, but that
end up resulting in lower returns. These five potentially devastating mistakes
can be avoided with knowledge, discipline and an alternative approach. (For
more strategies that you can use, check out Strategies for Part-Time Forex
Traders.)
Averaging Down
Traders often stumble
across averaging down. It is not something they intended to do when they began
trading, but most traders have ended up doing it. There are several problems
with averaging down.
The main problem is that
a losing position is being held - not only potentially sacrificing money, but
also time. This time and money could be placed in something else that is
proving itself to be a better position.
Also, for capital that is
lost, a larger return is needed on remaining capital to get it back. If a
trader loses 50% of her capital, it will take a 100% return to bring her back
to the original capital level. Losing large chunks of money on single trades or
on single days of trading can cripple capital growth for long periods of time.
While it may work a few
times, averaging down will inevitably lead to a large loss or margin call, as a
trend can sustain itself longer than a trader can stay liquid - especially if
more capital is being added as the position moves further out of the money.
Day traders are
especially sensitive to these issues. The short time frame for trades means
opportunities must be capitalized on when they occur and bad trades must be
exited quickly. (To learn more on averaging down, check out Buying Stocks When
The Price Goes Down: Big Mistake?)
Pre-Positioning for News
Traders know the news
events that will move the market, yet the direction is not known in advance. A
trader may even be fairly confident what a news announcement may be - for
instance that the Federal Reserve will or will not raise interest rates - but
even so cannot predict how the market will react to this expected news. Often
there are additional statements, figures or forward looking indications
provided by news announcements that can make movements extremely illogical.
There is also the simple
fact that as volatility surges and all sorts of orders hit the market, stops
are triggered on both sides of the market. This often results in whip-saw like
action before a trend emerges (if one emerges in the near term at all).
For all these reasons,
taking a position before a news announcement can seriously jeopardize a
trader's chances of success. There is no easy money here; those who believe
there is may face larger than usual losses.
Trading Right after News
A news headline hits the
markets and then the market starts to move aggressively. It seems like easy
money to hop on board and grab some pips. If this is done in a non-regimented
and untested way without a solid trading plan behind it, it can be just as
devastating as placing a gamble before the news comes out.
News announcements often
cause whipsaw-like action because of a lack of liquidity and hair-pin turns in
the market assessment of the report. Even a trade that is in the money can turn
quickly, bringing large losses as large swings occur back and forth. Stops
during these times are dependent on liquidity that may not be there, which
means losses could potentially be much more than calculated.
Day traders should wait
for volatility to subside and for a definitive trend to develop after news
announcements. By doing so there is likely to be fewer liquidity concerns, risk
can be managed more effectively and a more stable price direction is likely.
(For more on trading with news releases, read How To Trade Forex On News
Releases.)
Risking More Than 1% of Capital
Excessive risk does not
equal excessive returns. Almost all traders who risk large amounts of capital
on single trades will eventually lose in the long run. A common rule is that a
trader should risk (in terms of the difference between entry and stop price) no
more than 1% of capital on any single trade. Professional traders will often
risk far less than 1% of capital.
Day trading also deserves
some extra attention in this area. A daily risk maximum should also be
implemented. This daily risk maximum can be 1% (or less) of capital, or
equivalent to the average daily profit over a 30 day period. For example, a
trader with a $50,000 account (leverage not included) could lose a maximum of
$500 per day. Alternatively, this number could be altered so it is more in line
with the average daily gain - if a trader makes $100 on positive days, she
keeps losing days close to $100 or less.
The purpose of this
method is to make sure no single trade or single day of trading hurts the
traders account significantly. By adopting a risk maximum that is equivalent to
the average daily gain over a 30 day period, the trader knows that he will not
lose more in a single trade/day than he can make back on another. (To
understand the risks involved in the forex market, see Forex Leverage: A
Double-Edged Sword.)
Unrealistic Expectations
Unrealistic expectations
come from many sources, but often result in all of the above problems. Our own
trading expectations are often imposed on the market, leaving us expecting it
to act according our desires and trade direction. The market doesn't care what
you want. Traders must accept that the market can be illogical. It can be
choppy, volatile and trending all in short, medium and long-term cycles.
Isolating each move and profiting from it is not possible, and believing so
will result in frustration and errors in judgment.
The best way to avoid
unrealistic expectations is formulate a trading plan and then trade it. If it
yields steady results, then don't change it - with forex leverage, even a small
gain can become large. Accept this as what the market gives you. As capital
grows over time, the position size can be increased to bring in higher dollar
returns. Also, new strategies can be implemented and tested with minimal
capital at first. Then, if positive results are seen, more capital can be put
into the strategy.
Intra-day, a trader must
also accept what the market provides at different parts of the day. Near the
open, the markets are more volatile. Specific strategies can be used during the
market open that may not work later in the day. As the day progresses, it may
become quieter and a different strategy can be used. Towards the close, there
may be a pickup in action and yet another strategy can be used. Accept what is
given at each point in the day and don't expect more from a system than what it
is providing.
Bottom Line
Traders get trapped in
five common forex day trading mistakes. These must be avoided at all costs by
developing an alternative approach. For averaging down, traders must not add to
positions but rather exit losers quickly with a pre-planned exit strategy.
Traders should sit back and watch news announcements until the volatility has
subsided. Risk must be kept in check, with no single trade or day losing more
than what can be easily made back on another. Expectations must be managed, and
what the market gives must be accepted. By understanding the pitfalls and how
to avoid to them, traders are more likely to find success in trading. (To help
you become successful in the forex market, check out 10 Ways to Avoid Losing
Money In Forex.)
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