Are You Overtrading?
You are working hard at trading Forex and having some successes. Yet somehow, at the end of every month, you have ended up with a loss. What’s going on? You might be trading too much. Here’s how you can judge if you are overtrading, and how you can fix it if you are.
It is a natural human feeling to watch prices fluctuate and feel as if you should be actively involved in taking advantage of opportunities. After all, nobody wants to miss out on profits or sit back and watch a loss occur. These feelings are made worse by looking at price movements after they happen, especially when you forget that you are looking at them in hindsight. In most fields of life, you make more money by increasing your levels of effort, involvement, and activity within your business. The problem is, in trading Forex, stocks, or commodities, increasing your amount of buying and selling activity tends to lead to losses and not profits. Why is that?
Firstly, the markets do not care how much effort you put in or how hard you work, nor whether you get lucky or not. It is possible to make profits or losses over long periods of time just by having unusually good or bad luck. As humans we tend to feel we either deserve something or we do not.
How to Determine if You Are Overtrading
If my description of these negative feeling strikes a chord with you, you may be overtrading. If so, it is time for you to consider a few things in order to determine whether you are overtrading. Firstly, do you have a very strict criteria for entering a new trade? If so, do you follow it without exception? Good trade opportunities do not come along very often. In the Forex market, it is rare for there to be more then two or maybe three really good trade opportunities in a week (unless you are scalping, and even then you probably will not get more than the same number of overall setups to exploit, even if you are taking much more than two or three actual trades). If you are taking trades every day and looking for more than approximately 20 pips of profit, you are certainly overtrading.
The second thing to consider is the statistical basis of your entry strategy. For example, you may have opened an account with a Forex broker and read on their website to buy when the 10-period simple moving average crosses above the 50-period moving average on the 5-minute time frame. If you back test a strategy as simple as this on a short time frame like the 5-minute chart, you will quickly see that following such a strategy will cause you to lose your entire account very quickly. Some Forex brokers promote this kind of poor “overtrading” trading strategy because they make money when you lose, and they want you to lose money as quickly as possible so they can make money as quickly as possible! If you are using an entry strategy that is based on defined mathematical criteria, such as a moving average crossover, you should back test that strategy over several years and thousands of trades to check whether it is profitable. After all, you wouldn’t invest money in a business without learning something about it, so why would you invest your hard-earned trading deposit in a trading strategy whose performance you have not investigated? It is quite easy to make this kind of back test in Forex because you can easily get historical price data and create an excel spreadsheet to check it. Learning a little SQL and using that to make a back test is even easier and much quicker.
The Pareto Principle
Here is the golden rule of overtrading: the market does not give many good opportunities. Most of the time, there is no good trade entry available. A good way to understand this can be learning about the Pareto Principle, which states that 80% of profits come from less than 20% of opportunities (incidentally, this principle is relevant to other areas of life as well). The good news is that this is OK. For example, great investors who invest in hundreds of small companies do not work on the basis that they hope 60% of the companies will make profits while 40% will generate losses. They know that out of a hundred opportunities, they may get only two or three big winners, but that the profits there will be so huge they will more than compensate for the 97% of losers. Financial markets are not quite so extreme, but it is fair to say that the easiest way to make money in Forex is to not be in a trade most of the time. If you can show me someone who aims for 50 pips daily every day and makes significant profit after a year, I would be amazed.
I can illustrate this with a concrete example. I recently back tested six currency pairs over the past eighteen years to see how profitable various breakout strategies have been during this period. The most profitable set-up I was able to identify were breakouts involving exceptionally high volatility. Now, I looked at a total of almost 27,000 days, and the number of days when such a qualified breakout happened were less than 4,000. This means that the best opportunities were there only about 15% of the time. Interestingly, this number is not far from the Pareto Principle’s 20% guideline.
What if you are not following a rigid mathematical entry strategy, but relying upon your gut feel? This approach is perhaps even more prone to overtrading, as you are giving yourself a lot of discretion, and it is easy for most people to convince themselves that they are seeing what they want to see.
Be Picky with Trade Entries
To conclude, the essence of successful trading is to be very picky with your trade entries. These good entries are just not there most of the time. Successful traders must know how to stand aside and do nothing when the market is not giving any opportunities. You cannot force the market to give you an opportunity, you can only be ready to exploit the opportunities it gives you. There are many traders who have the skill to make money, who are taking the good trades, but who fritter their winnings away because they are unable to stand aside when the market is not providing good opportunities.
If you are entering more than three trades per week, and you are not a scalper, you are overtrading. If you do not have strict trade entry criteria and you find that your entries come along every day, you are overtrading. If you get bored when you don’t see any obvious entries and you talk yourself into entering new trades anyway, you are overtrading.
How to Stop Overtrading
So, if you are overtrading, how can you fix it? You need to have a very clear and strict method for finding trade entries and stick to it. You need to back test your method and make sure it has been profitable over a long period of time and keep faith with it. When there is no such entry opportunity, stand aside. Ignore your itchy trigger finger and don’t press the button. Try to see every day you do not trade as a day when you did not lose any money, unlike most other traders, and be proud of yourself for resisting temptation. When you go through a long period with very few (or even no) opportunities, comfort yourself that in financial markets, the darkest hour is often just before dawn. The opportunities will come eventually and the longer you are forced to wait, the better they are likely to be.