Monday, December 8, 2008
Step2 - Gain Knowledge
Continuing our FOREX Training we conclude that Trading knowledge mainly consists of three parts, Technical Analysis, Fundamental Analysis and Trade Management. In this FOREX Training course we will go through all three parts in order to build a solid foundation for the first Pillar to Profit, The Right Trading System. Click on the links below to study Fundamental Analysis and Technical Analysis:
Fundamental Analysis
Technical Analysis
Please read these in detail before you continue to Step 3 in your Forex training, else it will be confusing. I will address Trade Management further down.
The first thing you need to realize is that the best computer you can use is your mind. The mind, in order to support your endeavor, must create new neural pathways. The more time and effort you put into chart reading the more neural pathways will be developed and thus more complex patterns can be recognized and profitably acted upon. This is much more important than you might think, it just takes time to reach a point where the mind is saturated enough to help you become proficient.
Trading is a complex task and the price data is chaotic and volatile, sometimes very much so especially when economic reports are released. The best friend in trading is your mind, nothing can compare to its processing capacity or ability. The first thing you have to do is to study charts, as much as you can. However, do not try to push it too much, the mind needs time to process what it has learned and it is vital to let it take a breather.
Play around with the charts, different settings, different indicators – try to get a feel for what suits your trading style and personality. Soak that mind! In the beginning it will be confused and make mistakes, but hang in there and it will excel. Diligence and fortitude will pay off.
Another matter that you need to understand is that your old neural pathways are not assisting you to become a trader. In other words, not only do you need to create new neural pathways, but also get rid of the old that are detrimental to your success. What made you successful as an employee will probably not serve you in trading, especially if you want to trade intraday. Now, don't get too wind up in this, there is absolutely no need.
As I have stated above, the most important thing is to soak your mind with charts, to create new neural pathways. Slowly but surely your old pathways will make way for your new. Your mind is your best friend in the markets, the rest are just tools for you to make logical rules to trade by – reference points if you like.
Trade Management
Trade Management can literally make you or break you. Its one of the two things (the other is Trader Psychology) that novices and losing traders have little or no idea about. Trade management is divided into two closely related but separate subjects:
These are like the two sides of a coin. Two aspects of the same thing if you like. Money Management tells you how to handle a trade that is profitable and Risk Management how to handle a losing trade. As in any business (yes, trading is a business – thinking otherwise is foolish, you are in it to make money, right?), we want to maximize net profit, i.e income minus expenses. Your income is the sum of your profitable trades and expenses is the sum of the commission you have paid and losing trades.
Since most FOREX brokers get their income from the bid/ask spread instead of charging a commission we will leave it out here. Very simple then, winning trades minus losing trades. In order to maximize our net profit we need to maximize the value of our winning trades and minimize the value of our losing trades. Here enters Trade Management. A trader that excels at Trade Management can trade a mediocre system and still make a nice amount of money at the end of the day (week, month, year etc). The reverse is of course also true.
In theory, Trade Management sounds easy, but in practice it can be a real obstacle to trading success. In Money Management we want to maximize profits, to squeeze out the most we can from a price move. What makes it tricky is that we don't know where the price move will end. There are different techniques, but the most common are:
Risk Management tells you when to exit a losing trade or when to take a loss. We have the same problem here, we just don't know how far the price will move against us. The most common techniques are:
As you can see, the techniques of Risk and Trade Management are fundamentally the same. If you are reading this course, chances are that you are a novice trader. In this cases, use only a fixed Stop-Loss in the beginning. Actually fixed Stop-Losses are the best for any trader.
Regarding Money Management I suggest you choose the one that suits your Trading System, for example a trend-following Trading System is in some cases better off using an indicator-based, e.g. a Trailing Stop (a Trailing Stop is a trend-following stop, trailing price as it moves). If you want to use a Trailing Stop, then activate it rather late in the trade and keep it sufficiently wide. Personally I am not a big fan of Trailing Stops and you should know that Institutional Traders seldom use Trailing Stops (they usually use a "catastrophic" Stop-Loss, only to protect the bulk of their capital, but since retail traders do not have access to that amount of capital, they need to be more prudent). See picture below of a Volatility-based Trailing Stop:
Pay attention to the way the Volatility Stop is ballooning in the latter half of the picture. This is due to the increasing range (volatility) of the previous bars. As a result the Stop-Loss is now at a place much further from the actual price action, increasing risk but also keeping you in the trade. Be careful with too narrow trailing stops, they will strangle your trades and incur excessive trades (at least your broker will be happy by all the "commission" you are generating). Something else that is interesting about the picture is the way the Volatility Stop behaves when prices are bottoming out - look how the Trailing Stop is crossing back and forth before the uptrend begins. This is the big disadvantage of a Trailing Stop and the reason you should wait until the trend has established itself before activating or using the Volatility Stop.
Money Management is tricky and you can very seldom (if ever) exit at maximum trade profit. If you can squeeze out half the price move you are doing really well. Profit Targets are sometimes psychologically difficult to use, because they will keep you out of the big profits (the big trends), but on the other hand you will have more winners and steady profits. Profit Targets are not suitable for all systems, but if you trade a momentum-based system, they are definitely worth considering.
So where do you set your fixed Stop-Loss? This entirely depends on your Trading System. Some traders suggest that it is put either 1 pip below the previous lowest low (if you are long) or 1 pip above the previous highest high (if you are short) depending on your position. Please remember that this method can put you too far away and ruining your system by incurring excessive losses or too close not giving it enough freedom to maneuver into profit.
My point here is that you need to study the charts and figure out where to put them and at the same time take Position Sizing (see below) into regard. Then write it down and make it a rule. This is a very good exercise in chart reading, so please take this chance to soak your mind. For example, a combination of ATR and price action to determine your stop is a very good beginning.
Another way of setting a Stop-Loss is to calculate it from the predetermined Profit Target (if you have one) using the Risk/Reward-Ratio. The Risk/Reward-Ratio is simply the relation between your Profit Target, Stop-Loss and Entry Price. The Risk/Reward-Ratio should normally never be worse than 1:2 or
(Profit Target - Entry Price) / (Entry Price - Stop-Loss) >= 2
With the help of the above formula we can determine the Stop-Loss if we know the Profit Target and Entry Price. Use the following formula to calculate the Stop-Loss (assuming a Risk/Reward-Ratio = 2):
StopLoss = (3 * Entry Price - Profit Target) / 2
Lets say that you entered at 1.4136 (EURUSD). You believe from diligent chart study that the EURUSD will reach 1.4189. Using the formula above, you should put your Stop-Loss at 1.4110.
Breakeven Stop
When a position is starting to move in our favor (you have a small profit) it is wise to use a Breakeven Stop. In this way you are making sure that you are not losing anything even if the position suddenly starts moving against you. Basically a Breakeven Stop is our Stop-Loss that we move higher (if we are long) or lower (if we are short). Be careful when using the Breakeven Stop, if you move it too fast you will stymie your trade.
Position Sizing
There are many facets to Position Sizing and I will not deal with them all in this course. In order to keep it simple I will just tell you that you should never risk more than 5 % of your capital. If you start out small with an account of $2000, then you should not risk more than $100 (0.05 * $2000 = $100) on a single trade. In other words, your Stop-Loss should not exceed $100 or 100 pips if you trade the one mini contract ($10,000) of the EURUSD. Consider what I have said above about Trade Management, you need to adjust your Stop-Loss accordingly. I usually never risk more than 2 to 3 %, but some markets with high volatility could justify a higher percentage.
If you have enough capital, you could trade more than one lot, increasing the lots when you capital allows. If you want more insight into human behavior and Position Sizing, download and read Master Thesis “Position-sizing Effects on Trader Performance: An Experimental Analysis” by Johan Ginyard.
Tip: There is no such thing as a perfect Trading System. In the Trading community, a perfect system is called a Holy Grail System. Novices usually believe in the Myth of the Holy Grail and that they can find it. It doesn't exist. However, instead of just making you take my word for it, I will try to explain to you why it is simply impossible. The Holy Grail implies a system with 100% profitable trades and no or negligible draw-down. Now, financial time-series are dynamic, non-linear, non-stationary, noisy and chaotic in nature. Ask any scientist who have been trying to model financial time-series and he will confirm that they are among the most difficult to model. In many respects we still do not have the technology to accurately model financial time-series. Basically for the Myth of the Holy Grail to be true, we need to correctly predict not only every turning point, but also the exact extent of the move following the turning point – we don't want to trade noise. We need to buy at the lowest low and sell at the highest high. I don't know of anything or anyone who can predict the future with such an accuracy. And, yes, I have tried out neural networks and other machine learning techniques. Certain is that the common indicators used today do not even come close in helping us build an accurate model. For example, all common indicators (RSI, Momentum, Stochastic etc) are static and linear. Perhaps 20 years from now technology has advanced enough for us to get very close, but since the market is a living entity changing its inner workings on a regular basis, I honestly don't believe we will be able to make perfect forecasts within a foreseeable future. Besides, the day we figure out how to accurately model the markets, it will simply cease to exist, at least in a form that is predictable. So just forget about the Holy Grail and create a Trading System that works instead.
Action Step: If you haven't signed up for a Forex Training demo account, then the time is now right. I need you to start soaking your mind with primarily price charts. It doesn't matter if it is bar charts or Candlestick charts. Try out both and stick with the one you feel most comfortable with. Candlestick charts are better for the novice since you get an visual indication of the immediate trend, which can be helpful. After a few days, add an oscillator (for example RSI or Momentum) and a Moving Average (for example 20 bar length). Study their behavior and compare to the explanations in the TA primer. The important thing now is to study price behavior in raw form, smoothed and normalized. We are not interested in the specifics, but rather the general behavior. If you can teach your mind to generalize from what it sees now, the learning curve later on will be much shorter. Every week or so change the length of the Moving Average and exchange the oscillator in order to challenge the mind and force new neural pathways. After a few weeks you will have built a solid foundation for further Forex training. Do not take this action lightly, it will help you move on faster in the final steps.
Go to the next part, Step 3a.
Return from Forex Training to FOREX Trading Course
Fundamental Analysis
Technical Analysis
Please read these in detail before you continue to Step 3 in your Forex training, else it will be confusing. I will address Trade Management further down.
The first thing you need to realize is that the best computer you can use is your mind. The mind, in order to support your endeavor, must create new neural pathways. The more time and effort you put into chart reading the more neural pathways will be developed and thus more complex patterns can be recognized and profitably acted upon. This is much more important than you might think, it just takes time to reach a point where the mind is saturated enough to help you become proficient.
Trading is a complex task and the price data is chaotic and volatile, sometimes very much so especially when economic reports are released. The best friend in trading is your mind, nothing can compare to its processing capacity or ability. The first thing you have to do is to study charts, as much as you can. However, do not try to push it too much, the mind needs time to process what it has learned and it is vital to let it take a breather.
Play around with the charts, different settings, different indicators – try to get a feel for what suits your trading style and personality. Soak that mind! In the beginning it will be confused and make mistakes, but hang in there and it will excel. Diligence and fortitude will pay off.
Another matter that you need to understand is that your old neural pathways are not assisting you to become a trader. In other words, not only do you need to create new neural pathways, but also get rid of the old that are detrimental to your success. What made you successful as an employee will probably not serve you in trading, especially if you want to trade intraday. Now, don't get too wind up in this, there is absolutely no need.
As I have stated above, the most important thing is to soak your mind with charts, to create new neural pathways. Slowly but surely your old pathways will make way for your new. Your mind is your best friend in the markets, the rest are just tools for you to make logical rules to trade by – reference points if you like.
Trade Management
Trade Management can literally make you or break you. Its one of the two things (the other is Trader Psychology) that novices and losing traders have little or no idea about. Trade management is divided into two closely related but separate subjects:
- Money Management
- Risk Management
These are like the two sides of a coin. Two aspects of the same thing if you like. Money Management tells you how to handle a trade that is profitable and Risk Management how to handle a losing trade. As in any business (yes, trading is a business – thinking otherwise is foolish, you are in it to make money, right?), we want to maximize net profit, i.e income minus expenses. Your income is the sum of your profitable trades and expenses is the sum of the commission you have paid and losing trades.
Since most FOREX brokers get their income from the bid/ask spread instead of charging a commission we will leave it out here. Very simple then, winning trades minus losing trades. In order to maximize our net profit we need to maximize the value of our winning trades and minimize the value of our losing trades. Here enters Trade Management. A trader that excels at Trade Management can trade a mediocre system and still make a nice amount of money at the end of the day (week, month, year etc). The reverse is of course also true.
In theory, Trade Management sounds easy, but in practice it can be a real obstacle to trading success. In Money Management we want to maximize profits, to squeeze out the most we can from a price move. What makes it tricky is that we don't know where the price move will end. There are different techniques, but the most common are:
- Profit Target
- Indicator-based
Risk Management tells you when to exit a losing trade or when to take a loss. We have the same problem here, we just don't know how far the price will move against us. The most common techniques are:
- Fixed Stop-Loss
- Indicator-based
As you can see, the techniques of Risk and Trade Management are fundamentally the same. If you are reading this course, chances are that you are a novice trader. In this cases, use only a fixed Stop-Loss in the beginning. Actually fixed Stop-Losses are the best for any trader.
Regarding Money Management I suggest you choose the one that suits your Trading System, for example a trend-following Trading System is in some cases better off using an indicator-based, e.g. a Trailing Stop (a Trailing Stop is a trend-following stop, trailing price as it moves). If you want to use a Trailing Stop, then activate it rather late in the trade and keep it sufficiently wide. Personally I am not a big fan of Trailing Stops and you should know that Institutional Traders seldom use Trailing Stops (they usually use a "catastrophic" Stop-Loss, only to protect the bulk of their capital, but since retail traders do not have access to that amount of capital, they need to be more prudent). See picture below of a Volatility-based Trailing Stop:
Pay attention to the way the Volatility Stop is ballooning in the latter half of the picture. This is due to the increasing range (volatility) of the previous bars. As a result the Stop-Loss is now at a place much further from the actual price action, increasing risk but also keeping you in the trade. Be careful with too narrow trailing stops, they will strangle your trades and incur excessive trades (at least your broker will be happy by all the "commission" you are generating). Something else that is interesting about the picture is the way the Volatility Stop behaves when prices are bottoming out - look how the Trailing Stop is crossing back and forth before the uptrend begins. This is the big disadvantage of a Trailing Stop and the reason you should wait until the trend has established itself before activating or using the Volatility Stop.
Money Management is tricky and you can very seldom (if ever) exit at maximum trade profit. If you can squeeze out half the price move you are doing really well. Profit Targets are sometimes psychologically difficult to use, because they will keep you out of the big profits (the big trends), but on the other hand you will have more winners and steady profits. Profit Targets are not suitable for all systems, but if you trade a momentum-based system, they are definitely worth considering.
So where do you set your fixed Stop-Loss? This entirely depends on your Trading System. Some traders suggest that it is put either 1 pip below the previous lowest low (if you are long) or 1 pip above the previous highest high (if you are short) depending on your position. Please remember that this method can put you too far away and ruining your system by incurring excessive losses or too close not giving it enough freedom to maneuver into profit.
My point here is that you need to study the charts and figure out where to put them and at the same time take Position Sizing (see below) into regard. Then write it down and make it a rule. This is a very good exercise in chart reading, so please take this chance to soak your mind. For example, a combination of ATR and price action to determine your stop is a very good beginning.
Another way of setting a Stop-Loss is to calculate it from the predetermined Profit Target (if you have one) using the Risk/Reward-Ratio. The Risk/Reward-Ratio is simply the relation between your Profit Target, Stop-Loss and Entry Price. The Risk/Reward-Ratio should normally never be worse than 1:2 or
(Profit Target - Entry Price) / (Entry Price - Stop-Loss) >= 2
With the help of the above formula we can determine the Stop-Loss if we know the Profit Target and Entry Price. Use the following formula to calculate the Stop-Loss (assuming a Risk/Reward-Ratio = 2):
StopLoss = (3 * Entry Price - Profit Target) / 2
Lets say that you entered at 1.4136 (EURUSD). You believe from diligent chart study that the EURUSD will reach 1.4189. Using the formula above, you should put your Stop-Loss at 1.4110.
Breakeven Stop
When a position is starting to move in our favor (you have a small profit) it is wise to use a Breakeven Stop. In this way you are making sure that you are not losing anything even if the position suddenly starts moving against you. Basically a Breakeven Stop is our Stop-Loss that we move higher (if we are long) or lower (if we are short). Be careful when using the Breakeven Stop, if you move it too fast you will stymie your trade.
Position Sizing
There are many facets to Position Sizing and I will not deal with them all in this course. In order to keep it simple I will just tell you that you should never risk more than 5 % of your capital. If you start out small with an account of $2000, then you should not risk more than $100 (0.05 * $2000 = $100) on a single trade. In other words, your Stop-Loss should not exceed $100 or 100 pips if you trade the one mini contract ($10,000) of the EURUSD. Consider what I have said above about Trade Management, you need to adjust your Stop-Loss accordingly. I usually never risk more than 2 to 3 %, but some markets with high volatility could justify a higher percentage.
If you have enough capital, you could trade more than one lot, increasing the lots when you capital allows. If you want more insight into human behavior and Position Sizing, download and read Master Thesis “Position-sizing Effects on Trader Performance: An Experimental Analysis” by Johan Ginyard.
Tip: There is no such thing as a perfect Trading System. In the Trading community, a perfect system is called a Holy Grail System. Novices usually believe in the Myth of the Holy Grail and that they can find it. It doesn't exist. However, instead of just making you take my word for it, I will try to explain to you why it is simply impossible. The Holy Grail implies a system with 100% profitable trades and no or negligible draw-down. Now, financial time-series are dynamic, non-linear, non-stationary, noisy and chaotic in nature. Ask any scientist who have been trying to model financial time-series and he will confirm that they are among the most difficult to model. In many respects we still do not have the technology to accurately model financial time-series. Basically for the Myth of the Holy Grail to be true, we need to correctly predict not only every turning point, but also the exact extent of the move following the turning point – we don't want to trade noise. We need to buy at the lowest low and sell at the highest high. I don't know of anything or anyone who can predict the future with such an accuracy. And, yes, I have tried out neural networks and other machine learning techniques. Certain is that the common indicators used today do not even come close in helping us build an accurate model. For example, all common indicators (RSI, Momentum, Stochastic etc) are static and linear. Perhaps 20 years from now technology has advanced enough for us to get very close, but since the market is a living entity changing its inner workings on a regular basis, I honestly don't believe we will be able to make perfect forecasts within a foreseeable future. Besides, the day we figure out how to accurately model the markets, it will simply cease to exist, at least in a form that is predictable. So just forget about the Holy Grail and create a Trading System that works instead.
Action Step: If you haven't signed up for a Forex Training demo account, then the time is now right. I need you to start soaking your mind with primarily price charts. It doesn't matter if it is bar charts or Candlestick charts. Try out both and stick with the one you feel most comfortable with. Candlestick charts are better for the novice since you get an visual indication of the immediate trend, which can be helpful. After a few days, add an oscillator (for example RSI or Momentum) and a Moving Average (for example 20 bar length). Study their behavior and compare to the explanations in the TA primer. The important thing now is to study price behavior in raw form, smoothed and normalized. We are not interested in the specifics, but rather the general behavior. If you can teach your mind to generalize from what it sees now, the learning curve later on will be much shorter. Every week or so change the length of the Moving Average and exchange the oscillator in order to challenge the mind and force new neural pathways. After a few weeks you will have built a solid foundation for further Forex training. Do not take this action lightly, it will help you move on faster in the final steps.
Go to the next part, Step 3a.
Return from Forex Training to FOREX Trading Course
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