- There is a large chasm between trading and analysis.
- Analysis can assist with winning percentages, but this doesn’t always equate to profitability.
- Traders need to learn to manage risk if they ever hope to be consistently profitable.
While the title of this article can have broad implications with numerous explanations, we’re going to do our best to reduce the answer to this query to the most logical and basic explanation.
When a trader first gets started, it might be hard to imagine how getting control of losses can seem an impossible task. It may even feel like the cards are stacked against you… situations in which you’re right in your analysis, yet you still lose on the trade and watch capital disappear from your trading account.
So, a natural question is why some traders consistently make money while others lose, even when they’re right. That is what we will be investigating in this article.
The Difference between Trading and Analysis
Many new traders come to the market with a bias or point-of-view. Perhaps this is built from a background in economics, or finance, or maybe just a keen interest in politics. But one of the biggest mistakes a trader can make is harboring the expectation that ‘the market is wrong and prices have to come back.’
But let’s face it: Markets are unpredictable, and it doesn’t matter what type of analysis you use. As new information comes into the market, traders and market makers price it accordingly; because these folks don’t want to lose money just as much as you don’t want to lose money.
Is this to say that analysis is worthless? Absolutely not: It merely means that analysis is only a part of the equation of being a successful trader. Analysis is a way to potentially get the probabilities on the trader’s side, even if just a by a little bit; a way to maybe get a 51% or 52% chance of success as opposed to a straight-up coin flip.
Good analysis, whether it be fundamentally-driven or technically-driven, can be right a majority of the time. But no form of analysis will ever be right all of the time. And this is the reason that there is such a large chasm between analysis and trading.
In analysis, it doesn’t matter how wrong you are when you aren’t right. In trading, this matters quite a bit. Because even if you’re winning on 70% of your trades, if you’re losing $3 for every trade in which you’re wrong but only making $1 every time that you’re right, you’re still losing. It might feel good, because 70% of the time you’re walking away from your positions with the feeling of success; and as human beings this is something we generally strive for (to feel good).
The example below shows how bad risk management can destroy even a strong winning percentage of 70% success.
But logically, it doesn’t make sense to embark on this type of endeavor because the goal of trading is to make money; not necessarily to just ‘be right’ more than 50% of the time.
How to actually trade analysis
First thing first, traders need to crystallize what their actual goal is in trading in markets; and point-blank, that goal should be to make money.
After that, traders need to expect that they will, at times, be wrong.
So given these two facts, the next logical assumption is that without being able to control the damage from those instances in which we’re wrong, the prospect of profitability is a distant one.
So risk management isn’t just a preference or a style of trading: It’s a necessity for long-term profitability. Because even if you’re winning 90% of the time, the losses on the other 10% can far outstrip the gains that are made on the 90%.
I fully realize this isn’t necessarily exciting information. When I teach risk management, rarely do a see a student-trader ready to burst out of their seats to go and manage some risk. Most people want to hear about entry strategies, and analytical methods to try to get those odds of success tilted even higher in their favors.
But until a trader learns to manage their risk, much of this additional work is a moot point. Because as long as the risk exists that one bad position can and will wipe away the gain from many other ‘good’ positions; that trader is going to struggle to find profitability.
So, to properly trade analysis one needs to first observe proper risk management. Because trading isn’t just ‘guessing’ and ‘hoping’ that we get it right. Profitable trading is implementing analysis while properly managing risk factors; implementing a defensive approach so that when one is wrong, the losses can be mitigated and when one is right, profits can be maximized.
How can one begin to use ‘proper’ risk management?
We’ve already encountered one of the biggest mistakes of risk management, and that’s controlling the size of the losses relative to the size of the gains.
The solution is simple; implementing it not as much. As human beings, we often follow our gut instincts or our ‘feelings.’ But in trading, we have to keep the bigger picture in mind. When we place a trade, we often try to win on that one trade. This can keep traders holding on to losers for far too long, and closing out winners way too quickly.
Traders can adjust strategies to focus on lower-risk, higher reward types of setups
Image taken from How to Identify Positive Risk-Reward Ratios with Price Action; by James Stanley
The way to fix the Top Trading Mistake is to simply look to make more when you’re right than you lose when you’re wrong. That’s it. This can be done by setting stops and limits on every trade that is placed to reinforce that minimum 1-to-1 risk-to-reward ratio.
Unfortunately, risk management isn’t as simple as just setting a stop and setting a limit. After all, if a trader takes on a position that’s way too large relative to the size of their account, even if using a 1-to-2 or 1-to-3 risk to reward ratio; that one trade could completely wipe them out.
This is similar to the advice of ‘not putting all of your eggs in one basket.’ And while this concept is simple for equity investors that have seen stock prices fall off-of-a-cliff, highlighting the fact that investing in just one stock can be so dangerous, traders should look at the art of speculation in a similar light.
We discussed this topic in the article, Top Trading Mistakes, Part II: The impact of larger amounts of leverage. Not only does high leverage bring on a higher potential for failure, but highly-leveraged trades also amplify The Number One Mistake Forex Traders Make because more leverage amounts to even bigger swings in account equity.
We finished off the Top Trading Mistakes series with the third article, and this comes down to strategy selection. Even if a trader goes out of their way to prevent the top two trading mistakes, it doesn’t guarantee success. Holy Grail strategies don’t exist, and the best that a trader can do is to look to employ an approach befitting of that particular market’s condition.
If you’d like an example of how this can be done, the article How to Catch Swings in the Forex Market showed how traders can look to trade short-term reversals or swings with a constant eye on risk management.
--- Written by James Stanley
Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.
James is available on Twitter @JStanleyFX
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