Monday, August 30, 2010

Preserving Your Capital : Five Signals You are Taking Too Much Risk with Your Forex Trading

If you asked me what the most important aspect of trading is I would say : to preserve capital. This is something which is common to at least all the professional traders I know and something all new traders seem to lack. People new to forex trading like to trade their money like when they are gambling - the focus is to make money - while professionals trade so that they take the least possible risk on their capital (the focus is on preservation). I remember that when I was a new trader it was very hard to see when I was taking excessive risks, since the focus for new traders is in short term results, the real risk characteristics of the systems they use don't seem apparent until the market cashes on this risk and wipes the account or causes substantial losses.

On today's article I am going to give you some pointers that will let you know if you are trading with excessive risk. Certainly they won't cover all risky scenarios but you can be absolutely sure that if you feel identified with any of the signals highlighted below it is very likely that you will not be able to achieve long term profitability (at least until it is fixed) since you are taking a great exposure on your account which the market will eventually (with certainty) cash on. What are the red flags or signals that you are knee-deep into risky territory ? Keep reading to find out !

1. One loss has a significant emotional effect on you. When you are trading an account and a losing trade causes you any type of anguish, sadness or frustration it means that you are trading with a risk which is too high for you. One of the key ways to eliminate emotions in trading is to have short term results become meaningless to you from an emotional perspective, if a loss means something then it should be much smaller. Imagine that you had to burn a check for a given amount of money every single day. How small would that check need to be so that you could do it without any pain ? That is the maximum amount of money you should lose on each trade.

2. Your system has a historical ten year maximum draw down higher than 50%. When you are trading a system which in the past showed a maximum draw down higher than 50% it is very likely that this draw down will be much larger in the future. What happens here is that you are trading with a large enough risk so that your account will be wiped with a very good probability under evolving market conditions. The past - although a good guidance - should not be taken as if "the worst has already happened" always consider that a system will be able to double its maximum draw down in the future. As a rule of thumb you should reduce your risk so that the historical maximum draw down never reaches above 25%.

3. Your system cannot face twice the maximum number of historical consecutive losses. Also based on the above, the fact that a system has a given number of consecutive losing trades in the past does not mean that it will not have more in the future. It is undoubtedly possible and actually it happen rather frequently, that your system will face a "worse worst streak" in the future as market conditions evolve. You should always trade a system that can withstand twice the maximum number of past consecutive losses, otherwise you are assuming that the past already showed you the worst it could be, a rather naive assumption.

4. You cannot sleep. One of the easiest ways to recognize that you are using excessive risk levels in your trading is when you cannot sleep because you are thinking about the system you are using or the trades you have left open. If trading starts to mess with your sleep it is an absolutely clear and unequivocal sign that your risk level is way too high. As I said before, one of the keys to success is to make short term results meaningless and trading with low enough risk makes this a certainty.

5. You don't fully know your system or plan. Certainly a very risky element in trading is lack of knowledge about what you're doing. If you are trading in a certain way in which the long term profit and draw down targets are unknown then there is no way in which this system can be traded successfully over the long run. Trading a system or plan which has unknown profit and draw down characteristics is dangerous because you don't know the magnitude of the system's market exposure. It could cost you a significant portion of your account due to your lack of understanding.
Definitely my experience has shown me that a trader who answers "yes" to any of the above signals will face very hard problems in the long term as there is ample road for disaster. The good thing here is that simple steps can be taken to correct all these problems, understand the systems you are using, analyze their profit and draw down characteristics and trade with lot sizes and short term results that become meaningless to you.

If you would like to educate yourself in the building and creation of automated trading systems that are likely long term profitable with realistic and sound profit and draw down targets please consider joining, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach automated trading in general . I hope you enjoyed this article ! :o)

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