Sunday, February 28, 2010

Dollar Cost Averaging in Forex Trading... Is this a Sound Approach ?

I have been asked a few times questions about strategies for long term investments in the forex market. Precisely I have been asked a very important question about capitalization : if a person has a system which is very likely going to be long term profitable, how can that person add capital to his or her trading account ? I have given this a lot of thought since adding capital to investments is a great way to increase the power of compound return in the medium/long term. On the next few paragraphs I will try to explain my views about increasing trading capital on forex investment accounts and how I believe this should be done in order to maximize profitability and reduce the likehood of investing in a strategy which is bound not to continue working.

So what do I mean by adding capital ? If you start your trading account with 1000 USD and your trading system has a return of 12% a year in average then you will have approximately 3300 USD in ten years. However if you add 10 USD each month, your balance will be 5600 USD in the end. If you add capital to an investment which compounds you will eventually get much higher profits. This technique in which money is added every X period without taking into account the system's current state or market conditions is called "dollar cost averag" because it assumes that in the long term you will add as much money in favorable as in unfavorable conditions, therefore "averaging" the effect.

This technique works quiet successfuly in the stock market but I strongly believe that it is a very poor choice when adding capital to forex trading investments. The reason is simply that any forex trading system has a chance of eventually becoming too risky to be traded, regardless of the amount of proof of long term profitability. There is always the possibility that a set of market conditions will show that your system will not be able to handle appropiately. Therefore you run a great risk of investing in a strategy which no longer works appropiately when you invest using dollar cost averaging.

How do we increase our investments in forex trading then ? My answer to this question is called "reward the best". What I do is pretty simple : You save a given amount of money every month, without investing it on any trading system. You only add the money to a trading account if that account reaches a new equity high (meaning that the system is performing as it should) if it does not then you simply keep on saving the money. So for example, if you have a 1000 USD account and you would add 100 USD a month using dollar cost averaging here you will save those 100 USD every month of draw down until a new equity high is reached. The month this happens you add all the saved money to the account. So suppose that you start with 1000 USD, the first month you get 1020 USD so you add 100 USD reaching 1120 USD, the next month you are at 1095 so you save 100 USD, the following month you are at 1100 USD so you save the money again and finally on the next month you are at 1140 USD so you invest the 300 USD (past two draw down months plus this month).

I have found that this technique works great since it does not risk investing money in a system which is too risky while it rewards systems that reach new equity highs. In particular I have noticed that when the systems I have coded reach new equity highs, they tend to do that for a certain period of time before going into a draw down period, therefore, reaching a new equity high and investing then adds capitalization power to the following profitable period.

If you would like to learn more about my automated trading systems and how you too can design a trading system to reach your long term profitability goals please consider buying my ebook on automated trading or joining Asirikuy to receive all ebook purchase benefits, weekly updates, check the live accounts I am running with several expert advisors and get in the road towards long term success in the forex market using automated trading systems. I hope you enjoyed the article !

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