Do You Have Stars In Your Eyes?

An acquaintance asked my opinion about a trading venture the other day. A friend had told him about Forex trading and was going to send him details of a system guaranteed to make money.

In due course, he forwarded the system description to me and called enthusiastically seeking my feedback.

It was a trend following system with signals provided by cross over moving averages using 5 minute time periods. There were various filters, including ADX, stochastics, long term moving averages, and Bollinger bands. Everything but the kitchen sink!

There was no clear trade management strategy, and no exit plan.

I asked my friend what his expectations were. “Well”, he said, “I have put $1,000 into a trading account, so I don’t expect to start taking money out straight away. But if I can double up my capital each month, I should be able to start drawing a good income after about 6 months.”

I asked him if he understood the system, to which he replied: “No, not at all. I had no idea that all these technical indicators exist that let you determine what the market will do. I really do not understand the mathematics behind them, but I am assured there is no need to. All I need to do is use them.”

It never ceases to amaze me how normally sensible people believe that, when it comes to trading, they can set up a business returning 100% monthly on capital invested, and furthermore they can do it without extensive training, study or practice.

If you are looking at trading with similar stars in your eyes, then take a deep breath and get real!

If you were a fund manager on Wall Street with a record of returning 30% per annum on invested funds over, say, a twenty year period, you would be a lionised hero able to name your own salary. But our novice forex trader is eagerly anticipating returns of over 1000% in his first year of operation, using tools he does not understand.

After two days operating this system (fortunately on a demo account), my acquaintance had not seen any signals meeting all the criteria. He found it so boring that he had changed the time frame to 1 minute charts. In fact, unless he is fond of staring at a screen all day, he is better off trading a system like this on end of day data. This is emphatically NOT the kind of approach to use for day trading.

The other thing he needs to understand is that this kind of system does not provide regular income like a job. Most trend following systems have a low proportion of wins, but those wins are much bigger than the more frequent losses. It would be easy to go for several months in a loss situation before getting one of those big wins that takes you into the black – not much good if you want to take out money every month to pay the power bill.

In fact, all trading systems have bad patches, so the cash flow from them is always lumpy. But if you want a reasonably steady income, you need a system that has a positive expectation and trades frequently. If your system gives you two or three trades each day, then you will get through the draw down periods much faster. You will also find it easier to stick with your system if it has a win rate of 60% or more, even though you will have to sacrifice the big win/loss ratio to achieve this.

As for the battery of technical indicators, try not to be seduced by them. In my experience, they are worse than useless.

If you are a longer term trader, you want to be in a trend (long or short). If one glance at the chart doesn’t tell you there is a trend, stick to your day job. Trends tend to move in a series of waves, like an incoming tide. Each wave pushes further in the main trend direction, before pulling back a bit to gather up for another push. The best time to hop on a trend is during one of these pull backs.

If you are a shorter term trader, particularly a day trader, you have to understand support and resistance concepts, and build a trading plan around that. (Anyone who doubts the importance of support and resistance levels should observe the short term action in any heavily traded market, noting how, every time a support/resistance level is approached, there is a frenzy of activity as bulls and bears fight for supremacy.)

The simple moral of this article is that you need to think of trading like any other business. You need to capitalise it properly, have realistic expectations, and build a sensible operations plan to extract profits.

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