What is the Number One Mistake Forex Traders Make?

The Number One Mistake explained by professional Forex trading experts the “the Number One Mistake” FX trading team.

The Number One Mistake?

Big US Dollar moves against the Euro and other currencies have made forex trading more popular than ever, but the influx of new traders has been matched by an outflow of existing traders.

Why do major currency moves bring increased trader losses? To find out, the DailyFX research team has looked through amalgamated trading data on thousands of live accounts from a major FX broker. In this article, we look at the biggest mistake that forex traders make, and a way to trade appropriately.

What Does the Average Forex Trader Do Wrong?

Many forex traders have significant experience trading in other markets, and their technical and fundamental analysis is often quite good. In fact, in almost all of the most popular currency pairs that clients traded at this major FX broker, traders are correct more than 50% of the time:
The above chart shows the results of a data set of over 12 million real trades conducted by clients from a major FX broker worldwide in 2009 and 2010. It shows the 15 most popular currency pairs that clients trade. The blue bar shows the percentage of trades that ended with a profit for the client. Red shows the percentage of trades that ended in loss. For example, in EUR/USD, the most popular currency pair, clients a major FX broker in the sample were profitable on 59% of their trades, and lost on 41% of their trades.

So if traders tend to be right more than half the time, what are they doing wrong?
The above chart says it all. In blue, it shows the average number of pips traders earned on profitable trades. In red, it shows the average number of pips lost in losing trades. We can now clearly see why traders lose money despite bring right more than half the time. They lose more money on their losing trades than they make on their winning trades.

Let’s use EUR/USD as an example. We know that EUR/USD trades were profitable 59% of the time, but trader losses on EUR/USD were an average of 127 pips while profits were only an average of 65 pips. While traders were correct more than half the time, they lost nearly twice as much on their losing trades as they won on winning trades losing money overall.

The track record for the volatile GBP/JPY pair was even worse. Traders were right an impressive 66% of the time in GBP/JPY – that’s twice as many successful trades as unsuccessful ones. However, traders overall lost money in GBP/JPY because they made an average of only 52 pips on winning trades, while losing more than twice that – an average 122 pips – on losing trades.

Cut Your Losses Early, Let Your Profits Run

Countless trading books advise traders to do this. When your trade goes against you, close it out. Take the small loss and then try again later, if appropriate. It is better to take a small loss early than a big loss later. Conversely, when a trade is going well, do not be afraid to let it continue working. You may be able to gain more profits.

This may sound simple – “do more of what is working and less of what is not” – but it runs contrary to human nature. We want to be right. We naturally want to hold on to losses, hoping that “things will turn around” and that our trade “will be right”. Meanwhile, we want to take our profitable trades off the table early, because we become afraid of losing the profits that we’ve already made. This is how you lose money trading. When trading, it is more important to be profitable than to be right. So take your losses early, and let your profits run.

How to Do It: Follow One Simple Rule

Avoiding the loss-making problem described above is pretty simple. When trading, always follow one simple rule: always seek a bigger reward than the loss you are risking. This is a valuable piece of advice that can be found in almost every trading book. Typically, this is called a “risk/reward ratio”. If you risk losing the same number of pips as you hope to gain, then your risk/reward ratio is 1-to-1 (sometimes written 1:1). If you target a profit of 80 pips with a risk of 40 pips, then you have a 1:2 risk/reward ratio. If you follow this simple rule, you can be right on the direction of only half of your trades and still make money because you will earn more profits on your winning trades than losses on your losing trades.

What ratio should you use? It depends on the type of trade you are making. You should always use a minimum 1:1 ratio. That way, if you are right only half the time, you will at least break even. Generally, with high probability trading strategies, such as range trading strategies, you will want to use a lower ratio, perhaps between 1:1 and 1:2. For lower probability trades, such as trend trading strategies, a higher risk/reward ratio is recommended, such as 1:2, 1:3, or even 1:4. Remember, the higher the risk/reward ratio you choose, the less often you need to correctly predict market direction in order to make money trading.

Stick to Your Plan: Use Stops and Limits

Once you have a trading plan that uses a proper risk/reward ratio, the next challenge is to stick to the plan. Remember, it is natural for humans to want to hold on to losses and take profits early, but it makes for bad trading. We must overcome this natural tendency and remove our emotions from trading. The best way to do this is to set up your trade with Stop-Loss and Limit orders from the beginning. This will allow you to use the proper risk/reward ratio (1:1 or higher) from the outset, and to stick to it. Once you set them, don’t touch them (One exception: you can move your stop in your favor to lock in profits as the market moves in your favor).

the Number One Mistake Conclusion

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