Top 10 Mistakes of Forex Traders

The following is excerpted with permission of the publisher John Wiley & Sons, Inc. from The Little Book of Currency Trading: How to Make Big Profits in the World of Forex (Little Books. Big Profits) by Kathy Lien. Copyright (c) 2011 by Kathy Lien.

Most of the mistakes that traders make are not new and for those people who are able to avoid them from the very beginning, the path to successful trading will be smoother.  Whether you’re new to forex trading or have made some mistakes already, review this list of Top Ten Mistakes of Forex Traders and hopefully, it will save you a lot of time and money.

Mistake #1: Trading Out of Boredom or Anger. The trader’s high never goes away.   Regardless of whether you have been trading for a month, a year or a decade, there is always an initial adrenaline rush when you put on the trade.  However, being bored and seeking excitement is one of the worst reasons to trade.  When the markets are quiet and you are looking to put on a position, there is a very good chance that after scanning through a few charts over a few different time frames that you will convince yourself that the trade is right. Unfortunately what you are actually doing is forcing a trade, which can eventually lead to losses.  Professional traders wait for a currency pair to setup according to their plan and do not create a plan based upon the desire to trade.

Being angry is even worse than being bored.  Have you ever heard the saying that revenge is never sweet? The most dangerous time for any trader occurs right after a major loss. The instinct for revenge trading (the desire to get it all back at once) can be far more damaging than the initial loss, leading many traders to make impulsive, irrational decisions that often lead to complete destruction of the account.  It is much better to chip away at the losses by assuming less and less risk until the losses are recovered. This strategy stands in sharp contrast to what many novice traders do, which is to create even more risk by trying to revenge trade after a big loss.

Mistake #2: Having Unrealistic Expectations. I can never forget the one time that I encountered an overly eager trader at a Forex Expo who asked me if my trading returns were better than the winners of forex trading contests.  I responded by saying, “Considering that the winners make between 500 to 3,000 percent return in one month, which would equate to an yearly return of 6,000 to 360,000 percent, there is a very good chance that he is taking a lot of risk, trading irrationally using a strategy that he would never use if he was trading a significant amount of real money.  Usually these contests are either for demo trading accounts, mini and micros where the average account size is between $500 and $2,500.  Even the best fund hedge managers in the world are not able to make 1,000 percent return, let alone 360,000 percent return on a consistent basis.  Having unrealistic expectations encourages greater risk taking which is one of the primary reasons why many new traders blow up their accounts.  Seasoned forex traders are happy if they can beat the performance of the S&P 500 and elated if they can consistently generate double digit returns every year.  The key to being a successful forex trader is to approach it like any other asset class and to expect reasonable and not sky high returns.

Mistake #3: Taking Highly Correlated Trades. What many new traders cease to realize is that currencies will often move in the same direction. For example on any given day, if the Australian dollar is up against the U.S. dollar, there is a very good chance that the New Zealand dollar appreciated as well.  Many new forex traders will look at their charts and see that the AUD/USD and NZD/USD are breaking out at the same time and will naively go long both currencies. However, by doing so, the trader is basically doubling up on the same position.  This redundant exposure could be intentional but for most new traders it probably isn’t which can be a big mistake because if one comes crashing down, there is a good chance the other will follow.  The reason why currencies will move in the same direction is because of the U.S. dollar.  On most days, the U.S. dollar will be either up against all of the major currencies or down.  The magnitude of the moves will be different which may be a reason why a trader has decided to spread his risk between the AUD/USD and NZD/USD, but if that is not the intention, then rather than being diversified, the exposure is highly concentrated, which creates a hidden risk in the positions.

Mistake #4: Failing to Use a Stop. Another question that is asked often at Trade Shows is the importance of using a stop. I am always shocked to find out that many forex traders do not believe in using stops.  Their argument is that if they do not use a stop, the currency will eventually get back to their initial entry.  This is true until it isn’t.  When the trend in currencies is strong, it can move aggressively in one direction with little retracement.  Eventually it MAY get back to prior levels, but that could takes days, weeks, months, and sometimes even years.  Unfortunately markets can stay irrational far longer than most people can stay solvent, which means there may not be enough equity in the account to last until the currency pair finally gets back to its prior level.  It goes without saying that all traders should use a use a stop.  Trading at its core is ultimately an exercise in controlling the chaotic and often unpredictable markets.  If you do not use a stop you are at the mercy of the market and lose all control of your trade.  At that time, the best thing to think about is whether the trade would still be attractive if you were not already in the position.

Mistake #5: Taking Unnecessary Risks. New Yorkers are notoriously guilty of jaywalking.  Even 80 year-old grandmothers will avoid walking to the end of the street and waiting for the light to change before crossing.  However every time that I have seen an older person jaywalk it is over the weekend and in the early morning when most of the city is still sleeping.  With decades of life experience, grandmothers and grandfathers know that it is far less risky to jaywalk at a time when the city is deserted in an area that is relatively quiet than during rush hour in Times Square.  In fact, they would probably never jaywalk at that time and in that madness because it is an unnecessary risk.  When it comes to trading, holding a position over the weekend when the finance ministers and central bankers are holding a summit is an example of taking an unnecessary risk.  The outcome of these meetings is oftentimes unpredictable and can trigger a gap open on Sunday evening. Staying on top of upcoming news releases and events can help new traders avoid exposing the position to unnecessary risks.

Mistake #6: Being Too Patient With Losers and Not Patient Enough With Winners. Inexperienced traders are usually too patient with their losers and not patient enough with their winners.  Cut your losses quickly and let your winners ride is a common piece of advice that traders will receive.  However is it even more relevant to forex trading because of how strong trends can be.  Many traders fall victim to the mistake of nursing their losers until they become so large that it wipes out their account.  Some will even keep their losing trade open and trade around the losses hoping to recover at least some of it back.  Yet these are most likely the same traders who will abandon their trades as soon as it turns a small profit.  Unfortunately this is not the most efficient way to trade currencies.  It is generally smarter to bag a small profit early and leave open a part of the position in case the move begins a big one.

Mistake #7: Being a “Possum Trader”. If you have ever had a losing trade and decided to shut off your computer or walk away with the hope that it will turn around if you stopped watching it, then you have fallen victim to what my good friend Rob Booker calls Possum Trading. Leave the position open, close your eyes, cross your fingers and hope that the trade will work itself out.  Unfortunately this almost never happens and more often than not, the losses become even greater.  Trading is a game of survival and closing your eyes hoping that the fire will put itself out is not the right decision.  If it is a small fire, it is smarter put it out before it even comes close to burning down your house and if it is a large one, it is better to abandon your home and call in the firefighters. In trading, if the reason for the trade is no longer valid, then get out before the losses grow.  Don’t keep the trade on and turn into a possum.

Mistake #8: Taking on Too Much Leverage. In 2008 when I traveled to Dubai for the very first time and we were driving down Sheikh Zayed Road, which is the equivalent of Las Vegas Boulevard, I could not help but notice the glamorous buildings and the numerous construction projects in process. It felt like half of the world’s cranes were in a 5-mile radius.  Gulf News puts it was closer to 20 percent at the tome, which is still tremendous. Yet considering that at one point, the number of construction workers rivaled the number of Dubai citizens, it was clear that property developers were over leveraged and a bubble was forming.  When the bubble became too large, like it did in the United States, it burst causing prices to fall 60 percent from their peak.  The subprime turned financial crisis was a tough lesson in overleveraging.  Forex brokers will entice individual traders with very generous amounts of leverage but risking anything greater than 5 to 10 percent of your account on any one trade is financial suicide.  Leverage is a wonderful drug when the trade moves in your direction but it is pure poison when the market is aligned against you.

Mistake #9: Over Optimizing Your Strategy. Trading robots have become very popular over the past few years and savvier traders have even learned to code their own trading strategies and create mini algos.  However the biggest mistake that these traders make is over optimizing their strategy.  What may work perfectly in one market environment will not work so well in others.  Having spent a great deal of time creating systematic trading products, I have learned that most robots or algos work in either trend or range and rarely in both. So if someone is showing you backtested results with 1,000 percent returns, you should be highly skeptical because they have probably over optimized their robot to show you a perfect trading record that will be difficult to replicate in reality.    Markets are dynamic and their drivers change with time and therefore it is important to use the appropriate strategies in the right trading environments.  For example, applying trend following or breakout trading strategies in quiet range-bound environments will usually lead to be more losers than winners.

Mistake #10: Becoming a Demo Billionaire. Finally, don’t become a demo billionaire.  Nothing can replace live trading.  According to my business partner who loves to play videogames with his son, trading a demo is like playing HALO 3 and thinking that you are ready for war.  The moment you hear a shell explode near you in real life you’d pee in your pants.  Just because you can make 500 percent return in your demo doesn’t mean that you will be able to do the same in a live account.  Once you start to see losses of $1,000 or $5,000, nervousness will cause you to question whether you should remain in the trade.  One of the unique advantages of the forex market is that brokers provide new traders will different sized accounts that allows them to ease into live trading.  After making consistent profits on the demo for a few months, open up a mini trading account with a small amount of throwaway money.  Make sure you can handle the psychological element of trading real money before you commit greater amounts of capital.

Regardless of your risk tolerance, or whether you arrive at the airport an hour or three hours in advance of a flight, nobody likes to make a mistake. Reviewing this list of the Top 10 Mistakes might just save you from making one. Just make sure that you have a good reason for getting in and out of each trade and don’t get emotional!

Comments

[Michael Goode]

Mistake #0: Trading Forex. Forex trading is a zero-sum game at which most small time traders lose and lose big (as in lose a majority of their account). I would never touch forex, and I am a full-time stock day-trader.

[Zach]

This doesn't really sound like what I would expect from FMF. Is it a paid post? Aren't you supposed to make that pretty clear up front? Not impressed.

[FMF]

Zach --

I'm not impressed by your comment.

No, it's NOT a paid post (I don't do those.) It's an excerpt from a book (as noted in sentence #1.)

[Mike Hunt]

There is some really great advice in this article.

I don't trade forex but when investing I do find myself making the mistakes #5,6,7.

Thanks a lot for posting this- made me think.

-Mike

[MBTN]

Actually, I was impressed with Zach's comment. Yes it was a little snarky, but I've been accused of being snarky myself so I am willing to overlook that. Of course, FMF had an equally snarky retort, so I suppose it's all good!

I do agree with Zach's general point that this article seems to be a departure from the general philosophy of this website (get rich slowly, index funds, etc). Not that there is anything wrong with other points of view, but I would be interested to hear how FMF views currency trading and how it might fit in to the portfolio of the average reader.

I agree with Michael though. Currency trading make stock trading look safe by comparison. The only way I would "trade" currency is if I had some investment in a foreign currency that I want to hedge.

[FMF]

MBTN --

Zach went beyond being snarky -- he accused me of doing something unethical -- having a paid post without saying so. And based on what evidence? That he simply didn't like to post? That's why he got the response he did from me.

As for currency trading, I don't do it because I don't totally understand it -- and what I do understand, it seems very risky. That said, this piece is written by an expert and is not promoting a "get-rich-quick" mentality, so I thought it would be worth posting on the site for those people who may be interested in learning a bit about it.

[steveo]

If one was making these mistakes, they shouldn't even be allowed to own a computer, these are trite trivial regurgitations.

That said, FX trading in this modern day is more "honest" that equities, as equities have become the game of media, gov, brokers, and 20000 HAL 20000 computers. FX is highly gamed, but not highly manipulated on many levels.