Tuesday, December 25, 2007

Forex Trading : Why a Trading System is NOT enough

When people star trading the foreign exchange market one of the first things they are told is that if they intend to be profitable they have to find a trading system. By a system, people usually mean a simple or complex set of predefined rules which determine market entry points, exit points, lot sizes and such.

Well, this is one of the first things that turns 90% of forex traders into losers. Most traders hear this and immediately start their search for the so called "system". They start to learn about indicators, they start to dream about holy grails, they are confused. They start to build systems from scratch, they start to try other people's systems but they are never told that a simple system just won't do it.

The main reason why a professional forex trader is much better at trading than any expert advisor (feel free to debate this if you know an ea that can make 100% profit each month consistently) is because humans have a magical thing called discretion. Sure, it is a double bladed weapon, reason why most forex traders loose most of their money, they lack a proper sense of discretion.

Let us say we have Joe, who is a forex trader who has just started live trading after 4 months of paper trading and we have Magic. Magic is an expert advisor who is fitted to a strategy Joe has developed for the past six months. Magic trades exactly as the strategy is intended, never decides not to take a trade based on fear, greed, fundamentals or other factors. The ea just executes the strategy.

Joe on the other hand does not understand very well why the market moves, why that candlestick has a large shadow, why prices fluctuate the way they do. Joe is what some people would call a purely technical trader. Joe knows his strategy works for him as he used it for four months in paper trading, getting him a modest 30% profit.

Joe now starts trading in a live account. Magic does the same thing. Joe starts well but quickly looses his nerves when his open draw down starts to become larger with a bad trade. Stick to the system, he thinks. But then he remembers the two weeks of hard work it took to get those five hundred dollars he is now loosing, Joe exits the trade prematurely, before he looses a month's work.

The market then shifts completely after moving just another 10 pips against Joe's exit position, then it completely retraces back and gives Magic a 50 pip profit. Magic didn't know anything about fundamentals, it just did what it was programmed to do. After a while, Joe and Magic enter another positions. The move turns out to be a market whipsaw and both Joe and Magic hit their stoploss.

As you can see from our friends Joe and Magic. Joe, being a human with a very advanced brain, was behaving merely as a bad expert advisor. I mean, at least Magic was able to execute all of it's trades regardless of anything else, according to the strategy. Obviously Magic took a lot of unnecessary loses as it doesn't now any better (for example Magic didn't know the interest rates were about to change).

It is a shame that many traders behave this way. Like poorly programmed expert advisors. The reason why humans can outperform expert advisors greatly is because we can achieve proper discretion. A human can learn the psychological and fundamental reasons that drive prices, interpret price patterns, know when it is wise NOT to follow a strategy based on some other conditions that predict something else. But a human must learn this discretion from observation, trial and error.

This is why purely technical traders would at best perform exactly as an ea that employed their strategy, while other traders that use all the information available can perform better than any ea by reading the information available.

The key to trading is understanding the when, why and how of the market. Why does the price move ? When does it move ? and how does it move ? To understand this, one needs to involve things different than technical indicators and of course, one must learn to use human discretion in a positive manner. Discretion must work with you, not against you as it does for 90% of forex retail traders.

1 comment:

ckowyong said...

i agree that it's not easy to find a good Expert Advisor that can consistently generate profits month after month. it's best used as a "tool" to compliment your trading. it's excellent as a tool for generating trade alerts to the human trader to save time and effort in eye-balling the charts.

however, the recent developments during the 2007 Automated Trading Championship has led to many good ideas on how to make a good Expert Advisor... so i think we should be seeing some good ones hitting the EA marketplace soon.

as a matter of fact, 2nd place winner of the competition is already selling his EA... and from what i hear, it's flying off the shelves.

- ck (http://ckowyong.com/blog)

Daniel Fernandez's Expert Author Email Alerts
Sign up to receive email alerts of Daniel Fernandez’s latest articles from EzineArticles.com!

Email Address: