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Trading With Joe, or How Not To Lose Your Shirt In The Forex

-- by Stubby Candles
 

There are only two ways not to lose your shirt when trading in the Forex currency market. The first is not to be wearing a shirt in the first place. The second is to utilize proper position sizing and risk management.

Assuming that you are not trading from a nudist colony (in which case the term pips could take on entirely new meaning), we will focus here on the second possibility.

Being able to correctly forecast price direction a high percentage of the time is not difficult for even a relative newcomer (more on this below). So why don't more Forex traders succeed?

Is it because they lack the ability to recognize frequently recurring price patterns? Not likely. Most 12-year olds could learn to quickly recognize high-probability price patterns. We know because we've taught a few. If you don't believe us, practice for a few weeks then try beating any local teenager at Quake or Doom.

Is it because burgeoning grownup Forex traders can't learn a few simple rules? After all, most of the world's VCRs *are* still blinking on 12:00. Could Forex trading be less complicated than programming a VCR? Actually, yes.

Are you ready? Drum roll, please. The reason why most Forex traders lose money is because they lack self-discipline.

And why do they lack self-discipline? Who knows?

* Maybe they were the youngest child.
* Maybe they were the oldest child.
* Maybe they were the middle child.
* Maybe they never got in touch with their meaningful inner self.
* Maybe they were educated in the government schools. Oops! Can't go there.

Maybe, maybe, maybe... there is such a wide spectrum of differences in individual personality attributes that it's pointless to speculate.

Let's focus instead on how any Forex currency trader, no matter how wonderfully well adjusted or loveably dysfunctional s/he may be, can learn to execute a consistently high percentage of winning Forex trades.

First we begin with pattern recognition. Which begs asking: which pattern(s) shall we recognize?

In our experience the highest-probability, most frequently recurring and easiest to recognize patterns are rejections and reversals. These are also most easily spotted when using Japanese candlesticks.

There are two essential types of candlestick patterns: continuations and reversals.

* Continuation patterns are trickier to trade since it is always more challenging to forecast how far a move will go, or where it will end, than it is to spot where it begins (or began).

* Reversal patterns tend to be better defined since they represent a sudden change in trader sentiment (direction) by the 'Big Boys,' meaning the central banks and commercials that drive the majority of Forex volume.

This is neither the time nor place for an exposition on candlestick pattern recognition. There are several excellent books on the subject. Also, we teach beginner through advanced candlestick pattern recognition in our 'ForeXcellent Profits' currency trading/training course. So we will proceed on the assumption that the reader is thoroughly versed in candlestick pattern recognition.

What is the likely frequency of positive trades using these reversal/rejection patterns, in particular when trading the GBP/USD pair on the 15-minute chart?

Again, with our own experience as well as that of our best students as a guide, a 75%-80% correct price forecasting rate is highly realistic. Restated, we are saying that even a relative newcomer with perhaps three months of demo (practice account) trading under his or her belt will be able to correctly identify impending price direction as much as 3 out of 4; even 4 out of 5 trades.

But here is the crux of the matter: Does that mean that this same high percentage of correct pattern observations will automatically translate into a growing account balance? Not necessarily.

Here is where the rubber meets the road. Being right 4 out of 5 times does not necessarily mean that you will increase your account balance 4 out of each 5 times you trade.

And why not? Because proper position sizing and risk management must be utilized. Fail to do so and your average loser can be bigger than your average winner, and we all know what that spells: Divorce!

No, seriously, it spells 'draw down' and draw down can lead to 'margin call,' and margin call can lead to 'wipe out', a highly technical term that describes the situation perfectly. Wipe out your capital and you may have to drive a Frostee ice cream truck for an entire summer to refund your trading account.

Therefore, it is of critical importance that the trader know how much currency to control (i.e., how many contracts to place) on each trade, as well as where to place his stops and limits. This includes the management of variable exits, such as 'legging out' of a trade in stages.

Let us say that Trader Joe starts out trading a $10,000 account. He will size his trades at 2% of his capital, meaning that he will risk $200 on his first trade. That will be the extent of his possible loss. This is called 'truncated risk' and makes Forex one of the potentially safest trading vehicles known to man, when traded correctly.

By way of comparison, you can put your money in the hands of Wall Street's most highly touted mutual fund -- managed by thoroughly regulated and licensed traders -- and still lose most of it since you have absolutely no control over risk and there are no federal compensation, bailout or other 'free cheese' insurance programs for mutual funds loser. That was just in case you didn't know. (We teach stuff like this in our other home-study course which we call 'Two Steps To Wealth.')

Back to Joe. How exactly will Joe put $200 at risk? He will sit on his hands until he spots a high-probability trading pattern. He will determine where his protective stop needs to be placed (a critically important aspect of trading that we cover extensively in our course).

Let us say that Joe will be buying the GBP/USD pair and placing his stop just below a recent interim price low, perhaps also just below significant support (either a trend line or a pivot point). Joe gets out his compass and his protractor ... actually, Joe just eyeballs the distance from the proposed stop value to his buy price and sees that it is 30 pips away.

If Joe is trading at $1 USD a pip, he next divides the $200 he is willing to risk by the 30 pip stop and gets 6.666666666666 minis that he can place. Joe cannot trade a billionth of a mini (a mini controls $10,000 of currency per mini lot). That is because he cannot trade any fraction of a mini. So does he round up to the next whole mini, or round down?

Fortunately, Joe's trading platform allows him to trade 'micro' minis, each of which controls just $1,000 of currency at a value of $.10 (ten cents) per pip. Since the micro is 1/10th the size of the mini, Joe can now place 66 micros, in effect trading the equivalent of 6.6 minis. Voila! Joe's risk exposure is now fine-tuned.

Now here is where self-discipline enters the scene. Once Joe has placed the trade and set his stop, he closes his eyes, places his fingers on his temples and envisions himself affixing the stop to his trading screen with Crazy Glue (macho types might envision using a nail gun instead).

In any event, Joe will not move his stop, ever, under any circumstances, no matter what... *except* in the direction of profit. He will never, ever, move it *farther* away from its present location -- i.e., in the direction of loss.

TRADING TIP: We recommend to our students that they actually reach across with their right hand and shake their left hand, thereby making a deal with themselves that they will not screw this up.

Back to our story. Like Odysseus who ordered his sailors to lash him to the mast lest the Sirens' song lure his boat onto the rocks, Joe will ignore the conversations from the other people who live in his head (Fear, Greed, Pride, Impatience... did we mention Greed? ;-).

If the trade heads in Joe's direction, he will periodically move his stop up, only to lock in profits and guarantee himself some pips. If the trade starts heading south and drifts perilously close to his stop, Joe will place a towel over his head or over his computer monitor (or both) and stop looking at the screen.

If he simply can't stand the tension, he will turn the computer off and leave the office. If that doesn't work, we will fake a heart attack, dial 911 and call an ambulance. Anything to get away from the charts.

When he peeks in later (15 minutes later to be exact: see below), Joe will see that he either got stopped out or hit his profit objective. But, wait a minute...

So far we haven't mentioned placing a limit order to exit the trade with a profit, should price reach Joe's pip objective.

We have found from experience as well as from analysis of average price 'creep' per trading period (5 minutes, 15 minutes, etc.) that 12 pips is a realistic initial profit objective when trading the GBP/USD on the 15-minute chart. When trading the EUR/USD we go for 10 pips as our initial objective.

If we reach this initial objective we can do one of several things. We can close out the trade completely. Or we can close out half of our position, pocket those pleasantly profitable positive pips and think of them as the premium payment on a short-term 'casualty' insurance policy against the half of our original position that remains open. If necessary, we adjust our stop and come back 15 minutes later to see what happened.

And why 15 minutes later? Because we also forgot to mention that we taught Joe to trade on 'closed candles.' That is, to make all of his trading decisions at the end of each trading period (i.e., on the hour, at 15 minutes past the hour, etc.). Try it, you'll like it!

Trading on closed candles virtually eliminates trading anxiety and the almost irresistible human temptation to fiddle, meddle and tweak (sounds like a law firm we once hired).

So let's summarize: At precisely the close of a given 15-minute candle (because in this example Joe is trading on the 15-minute chart), Joe likes what he sees and decides to go for it.

He looks at his account balance, multiplies by 2% (or whatever risk position sizing he chooses to use), divides that amount by his stop and places the appropriate number of micros (or minis if that's the smallest contract size available).

If his account size allows him to place multiple contracts (at least 2, be they minis or micros), Joe sets the same stop value on each, but places a 12-pip initial profit objective on half of the contracts only.

Joe then leaves the room, closes the door behind him, and waits quivering in the hallway. Fifteen minutes later he returns to his computer to see that his trade is still open. Perhaps it has not neither stop nor limit and requires no adjustment. So Joe heads back out into the hall to play with his worry beads for another 15 minutes.

This pattern repeats itself until either the stop or the limit has been hit. If the latter, Joe decides whether or not to continue managing the half (or whatever portion) of his trade that remains open, perhaps by moving his stop to the next logical point and leaving the room again to go... you get the picture.

As it turns out, the missing link to successful Forex trading turns out not be prudent position sizing and trade execution, but Joe himself.

* Does Joe know how to recognize high-probability patterns? Yes.
* Does Joe know how to calculate proper position sizing? Yes.
* Does Joe know how to set stops and limits? Yes.
* Does Joe know how to stop being human? No, but he's getting there.

With increasingly cool detachment Joe now recognizes that his best efforts, indeed the best efforts of the best traders alive, will always generate 20% or more losing trades.

That he will probably never become as objectively rational as Mr. Spock on Star Trek who prided himself in having no emotion. That some small part of Joe will probably always trade like Barney Fife in 'Andy Of Maybury.'

In short, Joe is maturing as a trader. Like a mason building a castle, Joe is laying down a trading foundation, pip by pip. Soon he'll be able to install lavish surround sound in that castle and trade while he's watching reruns of Leave It To Beaver.

Ward Cleaver, now there's a guy who could learn how to trade!