How to Make Money on Forex:
Best Practices of Successful Traders
Every once in a while a good trade idea can lead to a quick and exciting pay-off, but professional traders know that it takes patience and discipline to be.
Successful Traders Cut Losses, Let Profits Run
Historically, this simple adage has been difficult to adhere to. Take the EUR/USD. Our data shows EUR/USD trades closed out at a profit 61% of the time. But the average losing trade was worth 83 pips while the average winner was only 48 pips. Traders lost 70% more on their losing trades than they won on winning trades. Remember that past performance is no indication of future results. Why the imbalance? Human behavior toward winning and losing can explain.
TRADERS LOSE MORE MONEY ON LOSING TRADES THAN THEY MAKE ON WINNING TRADES.
Imagine a wager. You have two choices. Choice A, we flip a coin. Heads, you win $1,000, and tails, you win nothing. Choice B, we flip a coin, but heads or tails, you win $450. Which would you choose? Over many flips, say 100, choice A makes sense. If you get heads half the time, you’d make $50,000. The more heads you get, the more you make. With B, the most you can make is $45,000. Human psychology suggests most people choose B, because the guarantee is perfectly acceptable.
Let’s flip the wager and run it as a loss. Choice A, heads you owe $1,000, and tails, you owe $0. Choice B, you owe $450 regardless of heads or tails. Again, psychology suggests the majority of people pick A every time. People avoid risk when it comes to a potential profit but accept risk to avoid a guaranteed loss. We take more pain from loss than pleasure from gain.
RISK VERSUS REWARD
HOW DO WE WIN MORE ON WINNING TRADES THAN WE LOSE ON LOSING TRADES?
When trading, follow a simple rule: Seek a bigger reward than the loss you risk.
This is called a risk-reward ratio. If you risk losing the same number of pips you hope to gain, then you risk-reward ratio is 1:1, meaning you set your stop and limit equidistant from your buy or sell price. If you take a 40-pip risk (stop) and target an 80-pip profit (limit), you have a 1:2 risk-reward ratio.
The higher the risk-reward ratio you choose, the less often you need to predict market direction correctly to make money. You should, however, use at least a 1:1 risk-reward ratio: If you are right only half the time, you break even.
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. Consider the coin flip wager. The tendency is to hold onto losses and take profits early. This is not the best strategy for proper risk management.
Instead traders should remove emotions from trading. A good way to do this is to set up your trade with stop and limit orders from the beginning. This allows you to use the proper risk-reward ratio (1:1 or higher) from the outset, and to stick to it.
Once you set stops and limits, don’t touch them!
GAME PLAN: USE STOPS AND LIMITS SET TO A RISK-REWARD RATIO OF 1:1 OR HIGHER.
When you place a trade, use a stop-loss order. Aim for at least 1:1 regardless of strategy. The actual distance you place your stops and limits depends on market conditions, such as volatility, currency pair and where you see support and resistance.
Successful Traders Use Leverage Effectively
Many traders come to the forex market for the wide availability of leverage — the ability to control a trading position larger than your available capital. However, while using high leverage has the potential to increase your gains, it can just as quickly, and perhaps more importantly, magnify your losses.
LEVERAGE—A DOUBLE-EDGED SWORD
Chart 4: Percentage of Profitable Traders by Average Effective Leverage.
Data source: HBL accounts excluding Eligible Contract Participants, Clearing Accounts, Money Managers, and Hong Kong and Japan subsidiaries from 3/1/2014 to 3/31/2015.
Profitability declines substantially as effective leverage increases: 40% of traders using an average effective leverage of 5:1 or lower turned a profit while only 17% using 25 :1 or higher closed at a profit.
EXCESSIVE LEVERAGE MAKES PROFITABILITY SIGNIFICANTLY LESS LIKELY.
Tom and Jerry each open a 10K account and look to trade EUR/USD (MMR $43 per 1K). Both use a 1:2 risk-reward ratio with a stop at 100 and a limit at 200. However, they use two different leverage ratios.
FINDING EFFECTIVE LEVERAGE
TO CALCULATE LEVERAGE, DIVIDE YOUR TRADE SIZE BY YOUR ACCOUNT EQUITY.
Knowing the link between leverage and equity is important. Now, you have to decide how much you are willing to risk and set your trading capital accordingly. To find effective leverage, consider two inputs: trade size and equity.
Say you open an account with $10,000 in equity. A 10:1 leverage would mean opening positions no larger than $100,000 at a time.
Chart 5: Percentage of Profitable Traders by Average Trading Equity
Given the relationship between profitability and leverage, you can see a clear link between average equity used and trader performance. At the low end, a mere 21% of traders with $1,000 equity turned a profit.
Those with more than $10,000 in equity were more than twice as likely to see profits. Those with under $1,000 in equity used an average of 28:1 leverage, while traders with more than $10,000 used an average of 5:1.
Chart 6: Average Effective Leverage Used by Average Trading Equity
GAME PLAN: USE EFFECTIVE LEVERAGE OF 10:1 OR LOWER.
Only risk 10% or less of your account balance at any given time. Add the cash value of your entire exposure to the market (all your trades), and never let that amount exceed 10 times your equity.
To calculate leverage of a single trade, divide your trade size by your account equity.
Successful Traders Trade The Right Time of Day
AS MARKETS OPEN AND CLOSE AROUND THE WORLD, HOW ARE MAJOR PAIRS AFFECTED?
Our data on trader performance shows that traders on average have a lower win percentage during volatile market hours and when trading through faster-moving markets. Conversely, when average pip movements are smaller, traders fair better, yielding higher win percentages.
Very quickly, you can see GBP/USD pip value varies significantly by time of day. On average, the pound was five times as volatile between 4:00 and 5:00 am as it was between 11:00 pm to 12:00 am.
Traders are generally more profitable when markets are less active.
How can you try to take advantage of these patterns? One way may be to mirror the simulated time-sensitive performance of the GBP/USD and trade like the straightforward range trader.
Let’s backtest it. Using an RSI strategy, we buy and sell when GBP/USD crosses RSI lines. The ‘Raw Equity’ is not filtered for the time of day. The ‘Filtered Equity’ is filtered to off hours, between 2:00 pm and 6:00 am New York time.
WHAT ABOUT OTHER CURRENCY PAIRS?
Of course, not all currencies are the same. The Japanese yen tends to see more volatility than its European counterparts through the Asian trading session because this is the Japanese business day.
Applying the same hypothetical strategy with and without the time filter, you can see USD/JPY doesn’t play as well as GBP/USD did.
Chart 7: Hypothetical Performance of RSI Trading Strategy in USD/JPY
Historically, time filters for off hours seems to us to have worked well for European currency pairs such as GBP/USD and EUR/USD.
GAME PLAN: TRADE EUROPEAN CURRENCIES DURING THE OFF HOURS USING A RANGE TRADING STRATEGY.
Trade European currencies during the off hours using a range trading strategy.
We believe that traders are generally more successful range trading European currency pairs between 2:00 pm and 6:00 am New York time. Asia-Pacific currencies seem difficult to range trade at any time of day as they tend to remain fairly active during Western off hours.
Automate your Asia-session trading with the Asia Range Grid from HBL Apps.
NEXT STEPS: PUT THESE TRAITS INTO ACTION!