• How to obtain and maintain an effective trading mindset
Obtaining
and maintaining an effective Forex trading mindset is the result of
doing a lot of things right, and it usually takes a conscious effort on
the trader’s behalf to accomplish this. It’s not necessarily difficult
to achieve, but if you want to develop an effective trading mindset, you
have to accept certain facts about trading and then trade the market
with these facts in mind…
You need to know what your trading strategy (trading edge) is and you need to master it.
You have to become a “sniper” in the market instead of a “machine
gunner”, this involves knowing your trading strategy inside and out and
having absolutely NO questions about what the market needs to look like
before you risk your hard-earned money in it.
You need to always manage your risk properly.
If you
do not control your risk on EVERY single trade, you open the door for
emotional trading to take hold of your mind, and I can promise you that
once you start down the slippery slope of emotional Forex trading,
it CAN be very hard to stop your slide, or even recognize that you are
trading emotionally in the first place. You can largely eliminate the
possibility of becoming an overly-emotional trader by only risking an
amount of money per trade that you are 100% OK with losing. You should
EXPECT TO LOSE on any given trade, that way you are always aware of the
very real possibility of it actually happening.
You need to not over-trade.
Most traders trade way
too much. You need to know what your trading edge is with 100% certainty
and then ONLY trade when it’s present. Once you start trading just
because you “feel like it” or because you “sort of” see your trading
edge…you kick off a roller coaster of emotional trading that can be very
hard to stop. Don’t start over trading and you will likely not become an emotional Forex trader.
You need to become an organized trader.
If there is
something that is the “glue” that holds all of the points I’ve discussed
in this part together, it is being an organized trader. By organized, I
mean having a trading plan and a trading journal and actually using
both of them consistently. You need to think of Forex trading like a business
instead of like a trip to the casino. Be calm and calculating in all
your interactions with the market and you should have no problem keeping
the emotional trading demons at bay.
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
• 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.
