We all know that Forex trading can be one of the riskiest types of trading (if you do not know what you are doing) because leverage can be used to control more money than we have in our accounts. However, when managed properly, I also believe that it can be one of the best markets to trade because of the liquidity, access to free data/tools and the very low transaction costs.
This post has actually been in draft status for over a year, because I was deciding if I should post it or not. I almost deleted it because I believe that you should take every possible precaution when trading.
But as I continue to refine and backtest trading strategies, there really is something to be said about playing it too “safe.” In this post, I will get into why this can be a bad thing, how to know you are doing it and the best way that I have found to prevent it.
Defining Safe
Let's get one thing straight: There can be many definitions of trading safe.
One definition is that you could have a trading system that you have backtested, forward tested and understand inside and out. You use proper money management and always follow the system. If the system has an extended drawdown (can happen with all systems), you demo trade until you get back on track.
That is the right way to do it.
But another definitions might include things like:
- Taking a smaller position size than normal at random times
- Exiting your trade too early to take profit off the table when there is no reason to
- Taking partial profits when that is not what you tested
- Not taking a trade because it doesn't “look good” even though you know that you need to take every setup to benefit from the advantage of your system.
Of course, these all sound like dumb things to do when you read them now, but they can seem like great things to do when you are actually in a trade. Take a minute to go through each of the items in the list above again and try to remember a time when you have done these things.
Sounded like a good idea at the time, right?
Let's figure out how to fix this…
Understand Your Expectancy
It all starts with knowing the expectancy of your system. Without getting too complicated, there are basically two parts to trading expectancy.
First, you need to know approximately how many of your trades will be winners. You can figure this out by looking at your backtesting or your actual trading results.
For example, in my last round of backtesting, I had 327 total trades, of which, 156 of them were profitable. This equates to a 48% win rate.
Second, you need to understand the approximate R Multiple of your trading system. The R Multiple is simply how many times larger your profit is than your risk. This can be measured in a couple of different ways.
You could measure it before you enter trades by dividing your dollar or pip profit target by your dollar or pips at risk. But since a lot can change during the course of a trade, it is usually better to take your average profit and divide it by your average loss. That way, you can get the results of what actually happened and not just what you intended to do.
Take your average win and divide that by your average loss, you will get the approximate R Multiple for your trading system.
When I look at the results from the same backtesting session mentioned above, my R Multiple is 2.73. This makes sense because I am targeting 3 times my risk for this system and sometimes I take my profit a little early, when price action tells me to.
Of course these statistics may change, but in order to achieve the results that you currently have (assuming they are good), your trading results will need to be around this level or better. If your R multiple or % wins start to drop, then your trading will not do as well.
Makes sense, right?
The Surefire Way To Kill Your Expectancy
So when you start doing things like taking smaller position sizes for no reason, exiting trades too early because you are scared of losing your profit, or ignoring trade setups, you effectively kill your R multiple.
Your winning % may go up a little, but you will not make enough on your winners to cover your losers. To put it another way, you are giving up the advantage of your trading method.
The Solution
In a previous post, I wrote about how profit taking can be a good thing, but only when done during times of uncertainty or if price got really close to your profit target and missed. The bottom line is that you need to have enough experience with your trading methods to know when you should exit a trade or when you should stick with it.
How do you know if you are doing things to decrease your expectancy? First, you need to have a trading system that has been tested to the point where you understand the characteristics of the system.
This includes things like:
- What were the maximum number of losers in a row?
- What is the best percentage of your account to risk on each trade?
- How do you know when you should take a break from trading?
- What is your average win percentage?
- What is your actual average R multiple?
- Anything else you can think of!
Then you need to continually track your results to see how your trading is doing in real-time. You can use online tools such as MT4i or MyFxBook. I personally like MyFxBook, but the choice is up to you.
Make sure that your trading is in line with your testing results. If they aren't, stop trading and figure out what is wrong. Remember that markets do change and you may need to alter your trading method.
So that is how trading too safe can adversely affect your results. There is a fine line between trading conservatively and doing things that will kill your edge in the market. The only way to figure it out is through experience.
If you don't know what to expect from your trading system, be sure to do some testing and figure out right now. Your success depends on it.
What do you you think? Is there such a thing as trading too safely?
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