For most traders, the hardest part of trading Forex is coping with financial losses. It is not simply a matter of pain and distress, but it is also a fact that losses are usually the catalyst that push traders into making their worst mistakes, which can then cause even greater losses, producing a vicious spiral in which the trader’s account spins out of control.
From this it follows that a trader must have a strategy in how he or she will cope with losses, and be able to execute that coping strategy. It is no use “knowing” that your losses are under control and how to keep them under control, if you cannot use the knowledge. Your coping strategy has to be real. You have to understand the logic behind your knowledge of losses and believe in its truth with total faith.
Losses are Inevitable
Losing trades are inevitable, in fact it is usually harder to make money with strategies that attempt to secure a very high win rate. This is just the nature of the way the market moves.
There are some traders that follow a methodology which attempts to greatly reduce or even eliminate losses completely. There are only two methodologies that can do this and it is important to understand them perfectly:
Adding to a losing trade in the belief you were right on the original trade entry, and only your timing was wrong. You can even add with a greater amount on the subsequent entry to make the recovery easier. The simple fact is that while this can work as a method, it is usually not optimal, and you will usually get better results by just accepting the first loss and closing the trade instead of attempting a “rescue”. After all, if your original “stop” was hit, why should the second trade be any better than the first?
“Turning with the wind” and opening a trade in the opposite direction. This is actually not “avoiding” a loss, it is in effect crystallizing a loss by changing your net position. If you are long 1 lot and then you go short 2 lots, you end up net short 1 lot with a crystallized loss on that long 1 lot.
There is one other thing you can do: not close losing trades, and let them run further and further against you. If you do this, you will eventually blow your account.
Hopefully, by now I have convinced you that you have to accept some losing trades. If I have not, then please go back and read it and read it again until you are convinced. If you are not convinced, please write to me and explain your reasons: hopefully I can convince you by email!
Know How Much Loss You Can Tolerate
One you have accepted you will have losing trades and go through losing streaks (known as “draw-downs), you have to decide how much you can psychologically tolerate losing without losing your nerve. To do this, you have to have an honest conversation with yourself. You might think you could cope with something like a 50% draw-down in your trading account, but in reality you could find yourself unable to cope even with 25% when it actually happens. Try to visualize it happening, close your eyes and place yourself there.
A second factor to consider is that as any draw-down in your account grows bigger, the amount you need to win back to get to the amount you started with increases. For example, if you lose 10%, you have to then grow the remaining 90% by 11.11% just to have the original 100% back. When you get to a very deep draw-down of 50%, you have to win 100% just to get back to the original 100%. It is a brutal fact that the deeper your losses, the harder it is to get back to where you started.
Having considered that, it is also true on the other hand that the less you risk, the less you will win when the trading does go in a favorable way.
Use a Trading Method that you Truly Believe In
Once you are sure of the maximum loss you can tolerate, you need to be sure that whatever method you are using to decide when to enter and exit trades and what to trade, it needs to be a good method that produces a positive “expectancy”. This means that over a large sample of trades, it makes more money than it loses.
You need to both believe it is a profitable method yourself, and also subject it to a back test over several years of historical data.
This is important because when you reach an inevitable losing streak, you will have the courage to keep going. If you don’t and you stop trading, or you lose your nerve and overtrade, you will miss out on the winning streak that will follow the losing streak.
Another advantage of a back test is that you can use a large, long-term back test to determine what the worst performance was in terms of draw-down and number of consecutive losing trades. You can use this to feel confident that you will be able to survive the losing streaks. For example, if the worst performance of your strategy over the past 10 years and thousands of trades is 50 consecutive losing trades, and the maximum draw-down you think you will be able to tolerate is 25%, that would suggest that if you risk 0.50% of your equity per trade, you will probably experience such a draw-down over the next 10 years. If you reduce risk to say 0.25% per trade, you make this depth of draw-down less likely to occur.
You should also use a fractional equity risk money management system, which gives you a greater peace of mind in knowing that there is a buffer to reduce the total losses of losing streaks. You can also decide that if you ever experience a draw-down much worse than the worst case of the past 10 years, that you will stop trading and re-examine your strategy.
Sometimes events happen in the market to trigger such large, sharp movements in price that even if you are using a stop loss, your broker will be unable (or will claim to be unable) to execute it. This means that when the stop is finally triggered, you might find yourself with much bigger losses than you were budgeting for. The Swiss Franc unpegging of 2015 was a good example of this. The Brexit vote last week much a much milder example.
You can avoid this problem by not trading any currencies whose central banks have a policy of swimming against the market’s tide by pegging value to another currency, and by not being in positions just before there is a large event risk from something scheduled such as a referendum.
Peace of Mind Will Help You Cope
When you have taken these measures outlined above, you can have the confidence to risk money on trades within the parameters you have defined. You will know roughly what percentage of trades tend to lose, how long the streaks tend to be, and most importantly that it eventually tends to come out ahead. At this stage, you have to accept that losing trades are natural, and are just necessary sacrifices you must make to the market in order to make money: a “cost of doing business”.