How to Make a Forex Trading Plan
Having
a Forex trading plan is one of the key elements to becoming a
successful Forex trader. Many traders never even make a trading plan,
let alone use one regularly. It’s very important that you do both; make a
trading plan and use the one you make…don’t just make one and then
never look at it like many traders do. Here are some important points to
consider regarding Forex trading plans:
• Follow a plan, have a journal, log trades
You need to do three essential things to become and remain an
organized and disciplined Forex trader. These things are the following:
1) Create a Forex trading plan,
2) Create (or use an existing) Forex trading journal,
3) ACTUALLY use BOTH of them.
The process of creating a Forex trading plan around an effective
trading strategy like price action trading, will work to solidify your
understanding of the trading strategy and will also provide you with a
blueprint for what you need to do each time you interact with the
market. Having this market blueprint is essential for developing the
type of ice-cold discipline that it takes to succeed in the Forex
currency market over the long-term.
Logging your trades in a trading journal is critical to your success
because it allows you to have a visual representation of your ability
(or lack thereof) to trade the markets, it also creates a track record
for you that you can use which will show you how your trading edge plays
out over time, this will allow you to ‘tweak’ and adjust your trading
strategy as you see fit.
• Trading plans contain a routine and check list
To
put it simply, you NEED to have a routine in your trading activities;
otherwise you will just end up running and gunning the seat of your
pants. I have a trading philosophy that revolves around trading Forex like a sniper and not a machine gunner,
if you want to trade like a sniper you have to have a routine that you
follow, and you have to be disciplined…a sniper in the military is an
extremely disciplined individual, and you need to think of the Forex
market like it’s a war, and you are a sniper trying to take only the
‘easiest prey’; your ‘prey’ in the markets consists of only the most
obvious trade setups.
Your trading plan should include a checklist that you follow; this
will include things that you look for in the market and what you want to
see before entering a trade. If you can tick all the boxes then you
enter the trade, if not then you hold off until your trading edge
appears again. You can actually formulate your whole trading plan as a
checklist; this will make it a smooth format that allows you to quickly
decide if any potential trade setup is worth taking.
Technical Analysis
Technical
analysis is the study of the price movement on a chart of a particular
Forex currency pair or other market. We can think of technical analysis
or “T.A.” for short, as a sort of framework that traders use to study
and make use of the price movement of a market.
The primary reason that traders use T.A. is to make predictions about future price movement based on past price movement.
Technical analysts believe that all current market variables are reflected via the price movement or price action
on a price chart. So, if we believe that all market variables are
reflected via price movement, it only goes to reason that we don’t
really need much else to analyze and trade the markets besides price. I
am a technical analyst and so are the members in my trading community,
we prefer T.A. because we agree with the idea that all market variables
are reflected via price action, so we see no reason to use other means
to analyze or trade the market. That’s not to say that having some
knowledge of fundamentals and news events is a bad thing, but we just
don’t rely on them heavily (we discussed Fundamental Analysis)
Technical analysts look for patterns on the chart that tend to repeat
themselves; they do this to develop their trading edge from. The
underlying logic here is that since most price movement is driven by
human beings, certain patterns will repeat themselves in the market as
human beings tend to be repetitive in their emotion and interaction with
the market.
Technical analysis also encompasses learning to analyze the market
structure; find trends, support and resistance levels and generally
learn to ‘read’ the ebbs and flows of a market. There is obviously
discretion involved here and I will be the first person to tell you that
T.A. is more of an art than a science. That said, it is something you
will get more comfortable with and better at given time and practice.
T.A. forms the back-bone of my core trading method of price action,
which is simply a derivative or off-shoot of ‘traditional T.A.”, except
with more clarity and more concise strategies that don’t involve
confusing forex indicators
or things like Elliot Wave Theory that are far too messy and open to
interpretation for me to believe they are worth trading or teaching.
Most traders instantly think of a price chart like the one above when
someone mentions the word “technical analysis”. Price charts provide us
with an amazing amount of useful data that paints a complete picture of
a market’s historical and current supply and demand situation, as well
as the price levels that the market participants have deemed the most
important. As technical analysts we need to pay special attention to
these price levels as price will tend to respect them again and again,
indeed, much of my price action trading course
is built around learning to identify and trade price action setups from
key levels in the market. Price charts are also a reflection of all
market participants’ beliefs about the market and market variables, so
by focusing your analysis and trading on a market’s price chart you can
streamline your trading and at the same time analyze the end result of
everything that contributes to the price movement of a market.
The urge to jump into the market and start trading real money is
often too much for most traders to withstand. However, the truth is that
until you have mastered an effective Forex trading strategy like price action trading,
you really should not be trading real money. By “mastering” the
strategy, I mean you should be consistently successful with it on a demo
account for a period of 3 to 6 months or more, prior to going live.
However, you don’t want to use demo account trading as a crutch…trading a
real account is different due to the real emotions involved, so just be
sure you switch to real-money trading after you have achieved success
on demo…don’t be afraid of trading real money, because eventually you
will need to make the switch to real money trading.
Also, be sure you are not just gambling your money away. Doing the
things we discussed above; over-trading, over-leveraging, not having a
trading plan, etc, these are all things that gambling traders do.
Traders who don’t gamble in the markets are calm and calculating…they
have a trading plan, a trading journal, and they know exactly what their trading edge is and when to trade it.
Not having a Forex trading plan is perhaps the most prevalent trading
mistake the Forex traders make. Many traders seem to think that they
will create a trading plan “later on” or after they start making money
or that they simply don’t need one or can just keep it “in their heads”.
All of these rationalizations are simply keeping traders from achieving
the success they so badly desire. If you don’t have a Forex trading plan
that details all of your actions in the market as well as your overall
trading approach and strategy, you will be far more likely to operate
emotionally and from a gambling mindset. Beginner traders especially
need a Forex trading plan to solidify their trading strategy and to
create a guide that they use to trade the market from, and you can’t
keep it in your head…you need to physically write out your trading plan
and read it every day you trade
Risk management is critical to achieving success in the markets. Risk
management involves controlling your risk per trade to a level that is
tolerable for you. Most traders ignore the fact that they COULD lose on
ANY TRADE. If you know and accept that you could lose on any trade…why
would you EVER risk more than you were comfortable with losing??? Yet
traders make this mistake time and time again…the mistake of risking too
much money per trade. It only takes one over-leveraged trade that goes
against you to set off a chain of emotional trading errors that wipes
out your trading account a lot faster than you think. Check out this
cool article on Forex money management for more.
• Over-trading
Most
traders do not make money in the markets over the long-run for one
simple reason: they trade way too much. One curious fact of trading is
that most traders do very well on demo accounts, but then when they
start trading real money they do horribly. The reason for this is that
in demo trading there is virtually no emotion involved since your real
money is not on the line. So, this goes to show that emotion is the #1
destroyer of trading success. Traders who over-trade are operating
purely on emotion.
Trading when your pre-defined trading edge is not actually present is
over-trading. Trading if you have no trading plan or have not mastered a
trading edge yet is over-trading. Essentially, you need to know EXACTLY
what you’re looking for in the market and then ONLY trade when your
edge is present. Trading too much causes you to rack up transaction
costs (spreads or commissions), and it also causes you to lose money a
lot faster since you are purely gambling in the market. You need to take
a calm and calculated approached to the market, not a drunken-gamblers
approach…which seems to be the favored approach of many traders.
There are common mistakes and ‘traps’ that give nearly all traders
trouble at some point in their trading careers. So, let’s cover the most
common mistakes that traders make which keep them from making money in
the markets:
• Analysis-paralysis
There is a virtually unlimited amount of Forex news
variables that can distract a trader, as well as tons and tons of
trading systems and trading software. You’ll need to sift through all of
these variables and forge a trading strategy that is simple yet
effective, warning; this can be a very a difficult task for beginner
traders.
The reason why, is that most traders seem to think that ‘more is
better’, when in reality ‘more’ is actually worse, as it relates to
Forex trading. There really is no need to sit in front of your computer
for hours on end analyzing Forex news reports or numerous indicators. My
trading philosophy is that all variables that affect a market’s price
movement are reflected via the price action on a price chart. So,
spending your time and money on trading software, systems, or analyzing
news variables is simply a waste. Furthermore, many traders get
analysis-paralysis, this occurs when a trader tries to analyze so many
market variables that they exhaust themselves to the point of making
silly emotional trading mistakes.
This could possibly be the most important Forex trading article you ever read. That
might sound like a bold statement, but it’s really not too bold when
you consider the fact that proper money management is the most important
ingredient to successful Forex trading.
Money management in Forex trading is the term given to describe the
various aspects of managing your risk and reward on every trade you
make. If you don’t fully understand the implications of money management
as well as how to actually implement money management techniques, you
have a very slim chance of becoming a consistently profitable trader.
I am going to explain the most important aspects of money management
in this article; risk / reward, position sizing, and fixed dollar risk
vs. percentage risk. So, grab a cup of your favorite beverage and follow
along as I help you understand some of the most critical concepts to a
profitable Forex trading career…
Risk : Reward
Risk reward is the most important aspect to managing your money in
the markets. However, many traders do not completely grasp how to fully
take advantage of the power of risk reward. Every trader in the market
wants to maximize their rewards and minimize their risks. This is the
basic building block to becoming a consistently profitable trader. The
proper knowledge and implementation of risk reward gives traders a practical framework to do this.
Many traders do not take full advantage of the power of risk reward
because they don’t have the patience to consistently execute a large
enough series of trades in order to realize what risk reward can
actually do. Risk reward does not mean simply calculating the risk and
reward on a trade, it means understanding that by achieving 2 to 3 times
risk or more on all your winning trades, you should be able to make
money over a series of trades even if you lose the majority of the time.
When we combine the consistent execution of a risk / reward of 1:2 or
larger with a high-probability trading edge like price action, we have
the recipe for a very potent Forex trading strategy.
Let’s take a look at the 4hr chart of Gold to see how to calculate
risk / reward on a pin bar setup. We can see in the chart below there
was an obvious pin bar that formed from support in an up-trending
market, so the price action signal was solid. Next, we calculate the
risk; in this case our stop loss is placed just below the low of the pin bar,
so we would then calculate how many lots we can trade given the stop
loss distance. We are going to assume a hypothetical risk of $100 for
this example. We can see this setup has so far grossed a reward of 3
times risk, which would be $300.
Now, with a reward of 3 times risk, how many trades can we lose out
of a series of 25 and STILL make money? The answer is 18 trades or 72%.
That’s right; you can lose 72% of your trades with a risk / reward of
1:3 or better and STILL make money…..over a series of trades.
Here is the math real quick:
18 losing trades at $100 risk = -$1800, 7 winning trades with a 3 R (risk) reward = $2100. So, after 25 trades you would have made $300,
but you also would have had to endure 18 losing trades…and the trick is
that you never know when the losers are coming. You might get 18 losers
in a row before the 7 winners pop up, that is unlikely, but it IS
possible.
So, risk / reward essentially all boils down to this main point; you have to have the fortitude to set and forget
your trades over a large enough series of executions to realize the
full power of risk / reward. Now, obviously if you are using a
high-probability trading method like price action strategies,
you aren’t likely to lose 72% of the time. So, just imagine what you
can do if you properly and consistently implement risk reward with an
effective trading strategy like price action.
Unfortunately, most traders are either too emotionally undisciplined
to implement risk reward correctly, or they don’t know how to. Meddling
in your trades by moving stops further from entry or not taking logical 2
or 3 R profits as they present themselves are two big mistakes traders
make. They also tend to take profits of 1R or smaller, this only means
you have to win a much higher percentage of your trades to make money
over the long-run. Remember, trading is a marathon, not a sprint,
and the WAY YOU WIN the marathon is through consistent implementation of
risk reward combined with the mastery of a truly effective trading
strategy.
Position Sizing
Position sizing is the term given to the process of adjusting the
number of lots you trade to meet your pre-determined risk amount and
stop loss distance. That is a bit of a loaded sentence for the newbie’s.
So, let’s break it down piece by piece. This is how you calculate your
position size on every trade you make:
1) First you need to decide how much money in
dollars (or whatever your national currency is) you are COMFORTABLE WITH
LOSING on the trade setup. This is not something you should take
lightly. You need to genuinely be OK with losing on any ONE trade,
because as we discussed in the previous section, you could indeed lose
on ANY trade; you never know which trade will be a winner and which will
be a loser.
2) Find the most logical place to put your stop
loss. If you are trading a pin bar setup this will usually be just above
/ below the high / low of the tail of the pin bar. Similarly, the other
setups I teach generally have “ideal” places to put your stop loss. The
basic idea is to place your stop loss at a level that will nullify the
setup if it gets hit, or on the other side of an obvious support or
resistance area; this is logical stop placement. What you should NEVER
DO, is place your stop too close to your entry at an arbitrary position
just because you want to trade a higher lot size, this is GREED, and it
will come back to bite you much harder than you can possibly imagine.
3) Next, you need to enter the number of lots or
mini-lots that will give you the $ risk you want with the stop loss
distance you have decided is the most logical. One mini-lot is typically
about $1 per pip, so if your pre-defined risk amount is $100 and your
stop loss distance 50 pips, you will trade 2 mini-lots; $2 per pip x 50
pip stop loss = $100 risked.
The three steps above describe how to properly use position sizing. The
biggest point to remember is that you NEVER adjust your stop loss to
meet your desired position size; instead you ALWAYS adjust your position
size to meet your pre-defined risk and logical stop loss placement.
This is VERY IMPORTANT, read it again.
The next important aspect of position sizing that you need to
understand, is that it allows you to trade the same $ amount of risk on
any trade. For example, just because you have to have a wider stop on a
trade doesn’t mean you need to risk more money on it, and just because
you can have a smaller stop on a trade does not mean you will risk less
money it. You adjust your position size to meet your pre-determined risk
amount, no matter how big or small your stop loss is. Many beginning
traders get confused by this and think they are risking more with a
bigger stop or less with a smaller stop; this is not necessarily the
case.
Let’s take a look at the current daily chart of the EURUSD below. We can see two different price action trading
setups; a pin bar setup and an inside-pin bar setup. These setups
required different stop loss distances, but as we can see in the chart
below we still would risk the exact same amount on both trades, thanks
to position sizing:
The fixed dollar risk model VS The percent risk model
Fixed dollar risk model = A trader predetermines how
much money they are comfortable with potentially losing per trade and
risks that same amount on every trade until they decide to change their
risk.
Fixed percent risk model = A trader picks a percentage of their account to risk per trade (usually 2 or 3%) and sticks with that risk percentage.
In a previous article that I wrote about money management titled “Forex Trading Money Management
– An Eye Opening Article”, I argued that using a fixed dollar amount of
risk is superior to the percent of account risk model. The primary
argument I make about this topic is that although the % R method will
grow an account relatively quickly when a trader hits a series of
winners, it actually slows account growth after a trader hits a series
of losers, and makes it very difficult to bring the account back up to
where it previously stood. This
is because with the % R risk model you trade fewer lots as your account
value decreases, while this can be good to limit losses, it also
essentially puts you in a rut that is very hard to get out of. What is
needed is mastery of one’s trading strategy combined with a fixed dollar
risk you are comfortable with losing on any given trade, and
when you combine these factors with consistent execution of risk /
reward, you have an excellent chance at making money over a series of
trades.
The % R model essentially induces a trader to ‘lose slowly’ because
what tends to happen is that traders begin to think “Since my position
size is decreasing on every trade it’s OK if I trade more often”…and
whilst they may not specifically think that sentence…it is often what happens. I
personally believe the % R model makes traders lazy…it makes them take
setups that they otherwise wouldn’t…because they are now risking less
money per trade they don’t value that money as much…it’s human nature.
Also, the %R model really serves no real world purpose in
professional trading as the account size is arbitrary; meaning the
account size does not reflect the true risk profile of each person, nor
does it represent their entire net worth. The account size is actually a
‘margin account’ and you only need to deposit enough in an account to
cover the margin on positions…so you could have the rest of your trading
money in a savings account or in a mutual fund or even precious
metals…many professional traders do not keep all of their potential risk
capital in their trading account.
The fixed $ risk model makes sense for professional traders who want
to derive a real income from their trading; it’s how I trade and it’s
how many others I know trade. Pro traders actually withdrawal their
profits from their trading account each month, their account then goes
back to its “baseline” level.
Example of Fixed $ Risk Vs. % Risk
Let’s take a look at a hypothetical example of 25 trades. We are comparing the fixed $ risk model to a 2% account risk model. Note:
We have chosen the 2% risk because it’s a very popular percent risk
amount amongst newbie traders and on many other Forex education sites.
The fixed $ risk was set at $100 per trade in this example just to show
how a trader who is confident in his or her trading skills and trades
like a sniper would be able to build his or her account faster than
someone settling on a 2% per trade risk. In reality, the fixed $ risk
will vary between traders and it’s up to the trader to determine what
they are truly OK with losing per trade. For me, if I was trading a
small $2,000 account, I would personally be comfortable risking about
$100 per trade, so this is what our example below reflects.
It’s quite obvious upon analyzing this series of random trades that
the fixed $ model is superior. Sure you will draw your account down a
bit quicker when you hit a series of losers with the fixed $ model, but
the flip side is that you also build your account much quicker when you
hit a series of winners (and recover from draw downs a lot faster). The
key is that if you’re really trading like a sniper
and you’ve mastered your trading strategy…you’re unlikely to have a lot
of losing trades in a row, so the fixed $ risk model will be more
beneficial to you.
In the example image below, we are looking at the fixed $ risk model versus the % risk model:
Now this example is a bit extreme, if you are trading with price action trading strategies
and have truly mastered them, you shouldn’t be losing 68% of the time;
your winning percentage is likely to average close to 50%. You can
imagine how much better the results would be with a 50% winning
percentage. If you won 50% of the time over 25 trades while risking $100
on a $2,000 account, you would have $4,500. If you won 50% of the time
over 25 trades while risking 2% of $2,000, you would have only about
$3,300.
Many professional traders use the fixed dollar risk method because they know that they have mastered their forex trading strategy,
they don’t over-trade, and they don’t over-leverage, so they can safely
risk a set amount they are comfortable with losing on any trade.
People who trade the %R model are more likely to over-trade and think
that because their dollar risk per trade is decreasing with each loser
it’s OK to trade more trades (and thus they lose more trades because
they are taking lower-probability trades)…and then over time this
over-trading puts them much further behind a fixed $ trader who is
probably more cautious and sniper- like.
Conclusion
To succeed at trading the Forex markets, you need to not only thoroughly understand risk reward,
position sizing, and risk amount per trade, you also need to
consistently execute each of these aspects of money management in
combination with a highly effective yet simple to understand trading
strategy like price action. To learn more about price action trading and
the money management principles discussed in this article
While we are talking about different ways of trading the Forex
market, I want to touch on what I feel is a widely believed “myth”
regarding automated robot and indicator-based trading systems…
You are probably going to come across many Forex website selling
Forex software that they claim will fully mechanize the process of
trading, so that all you have to do is click your mouse when the
software tells you to and then rake in the profits. You need to
constantly keep in mind the old saying “If it sounds too good to be true
it probably is…” when you are learning to trade Forex. Like I said
before, you are probably going to come across a lot of these robot
websites if you have not already. You are best served by ignoring them
all together.
You will probably see track records that they claim are
“indisputable” evidence of the robots performance in the markets…what
they don’t tell you is that this track record is simply a display of a
“perfect” set of data that the software was back-tested on. The point is
that trading software cannot work over the long-term because the market
is constantly changing and as such, it takes the discerning discretion
of the human brain to effectively trade the markets over the long-term. I
am not saying that computer software has no place in trading, but it
cannot be the only thing you rely on, and it certainly should not be
used in attempt to fully-automate the trading process. The ability to
read the raw price action of a market and grow and evolve with the
ever-changing conditions of the market is how I personally trade and how
I teach my students to trade.
• Trend trading
Trending markets offer us the best opportunity to profit, since the
market is clearly moving in one general direction; we can use this
information to our advantage by looking to enter the market in the
direction of the trend.
An uptrend is marked by a series of higher highs and higher lows, and
a downtrend is marked by a series of lower highs and lower lows. Note
that trends do end, as we can see in the daily EURUSD chart below, the
downtrend has come to an end recently after the pattern of lower highs
and lower lows was broken…
I like to trade with the near-term daily trend by looking for high-probability price action strategies
forming within the structure of the market trend. What I mean by this
is essentially looking for price action setups forming near support as a
market rotates lower in an uptrend and near resistance as a market
rotates higher in a downtrend. Markets ebb and flow, and if you can
learn to take advantage of trending markets, you will have a very good
shot at becoming a profitable Forex trader:
• Counter-trend trading
Since trends do end, we can also take advantage of this information.
However, counter-trend trading is inherently riskier and more difficult
than trading with the trend, so it should only be attempted after you
have fully mastered trading with the trend. Some of the things to look
for in a good counter-trend signal is a price action pattern or setup
forming at a very obvious and ‘key’ support or resistance level on the
daily chart, see here:
• Range-bound market trading
When a market is in a trading range it means that it is consolidating
between a level of support and resistance. We can use the fact that a
market is bouncing between support and resistance to our advantage. As
the market approaches the support or resistance boundary of the trading
range, we have a high-probability entry level, since risk is clearly
defined just above or below the resistance or support of the range. When
trading price action in trading ranges, you can watch for obvious price
action setups forming near the boundaries of the range, see here:
• Forex candlestick charts and patterns
We discussed Forex charts in Part 7, but as they are very important
to the way that I trade and teach price action, I wanted to give them a
little more time. I have previously written an excellent tutorial on
Forex candlestick charts that you can check out here: Forex candlestick charts
It’s important to understand that candlestick patterns have certain
terminology all to their self that you should become familiar with
before you attempt to master a trading strategy like price action.
There are many different Forex trading strategies.
However, there are some basics of reading a price chart that you need
to know before you can move on to learning any one strategy in-depth.
Let’s cover the basic building blocks of trading the Forex market from a
technical analysis approach:
• Support and Resistance levels – How to identify and plot them
Support levels are created as a market turns higher. So, if a market
is moving lower for example and it then changes direction and begins
moving higher, it either has created a level of support or bounced off a
previously existing level of support.
Resistance levels are created as a market turns lower. So, if a
market is moving higher for example, and it then changed direction and
beings moving lower, it either has created a level of resistance or
bounced off a previously existing level of resistance:
Identifying and plotting support and resistance levels
is by no means an exact science. Instead, it requires the use of the
discerning human eye and a little bit of brain power…don’t be worried
though, it’s really not that difficult to become proficient and
confident in drawing support and resistance levels on your charts.
In the chart below, we can see the daily GBPUSD chart, with all the relevant support and resistance levels drawn in:
Now, one important point that I want you to know about support and
resistance levels is that they are not concrete. Many traders seem to
think support and resistance levels are concrete and that they should
never trade a setup if there is a support or resistance level close by,
this can result in them getting analysis paralysis and never entering a
trade. While it is true that you need to take into consideration the key
support and resistance levels in the market, you also need to look at
the overall market condition. You see, in trending markets, support and
resistance levels will often be broken by the trend momentum; so don’t
be afraid of support and resistance levels, as they will often break.
Instead, watch these levels for trading signals. You see, when a Forex
trading signal like a price action setup forms at a key support or
resistance level, it is a very high-probability even to take notice of.
