10 Big Mistakes Forex Day Traders Make
Your success depends on avoiding these pitfalls
The forex, or foreign exchange market, has low barriers to entry, making it one of the world's most accessible day trading markets. If you have a computer, an internet connection, and a few hundred dollars, theoretically you can start day trading. That doesn't make it easy to make a profit, though. Before you take the plunge, consider these 10 common mistakes you must avoid, as they are the main reasons new traders fail.
If you keep losing, don't keep trading
There are two trading statistics to keep a close eye on: Your win-rate and risk/reward ratio.
Your win-rate is how many trades you win, expressed as a percentage. For example, if you win 60 trades out of 100, your win-rate is 60%.
A day trader should maintain a win rate above 50%.
Your reward/risk ratio is how much you win relative to how much you lose on an average trade. If your average losing trades are $50 and your winning trades are $75, your reward/risk ratio is $75/$50=1.5.
As a day trader you want to keep your reward/risk above 1, and ideally above 1.25. Those statistics indicate a profitable trader.
You can still be profitable if your win-rate is a bit lower and your reward/risk is a bit higher, or if your reward/risk is a bit lower but your win-rate a bit higher.
Try to keep it simple though, and use strategies that win more than 50% of the time and offer a better than 1.25 reward/risk ratio.
Never trade without a stop loss
Have a stop loss order for every single forex day trade you make. A stop-loss is an offsetting order that gets you out of a trade if the price moves against you by an amount you specify.
Your loss is moderated. Take it and move on to the next trade.
Never add to a losing day trade
Averaging down is adding to your position as the price moves against you, in the usually mistaken belief that the trend will reverse.
Adding to a losing trade is a dangerous practice. The price can move against you for much longer than you expect, as your loss gets exponentially larger.
Instead, take a trade with the proper position size and set a stop loss on the trade. If the price hits the stop loss the trade will be closed at a loss. There is no reason to risk more than that.
Don't risk more than you can afford to lose
The key part of your risk management strategy is to establish how much of your capital you are willing to risk on each trade.
Day traders ideally should risk 1% or less of their capital on any single trade. That means that a stop loss order closes out a trade if it results in no more than a 1% loss of trading capital.
That means that even if you lose multiple trades in a row only a small amount of your capital will be lost. At the same time, if you make 2% or 3% on each winning trade your losses are easily recouped.
Another aspect of risk management is controlling daily losses. Even risking only 1% per trade, you could lose a substantial amount of your capital in a single bad day.
Every day trader should have a daily stop loss. If you lose, say, 3% of your capital in one day, stop trading for the day.
Never go all in
Even if you have a risk management strategy in place, there will be times you are tempted to ignore it and take a much larger trade than you normally do.
The reasons vary. You have had several losing trades in a row, and you want to make back some losses. You are trading very well lately, and feel like you can't lose. You feel so confident about this particular trade that you are willing to risk almost everything on it.
Stick to your 1% risk per trade rule and your 3% risk per day rule.
If you risk too much you are making a mistake, and mistakes tend to compound. If your risk doesn't pay off, you may cancel your stop loss order in the hopes of a turnaround. You may add to the position, betting that it will turn around eventually.
Avoid such temptations. Stick to your risk management strategy and avoid going all in.
Don't try to anticipate the news
Many pairs rise or fall sharply in the wake of scheduled economic news releases. Anticipating the direction the pair will move, and taking a position before the news comes out, seems like an easy way to make a windfall profit. It isn't.
Often the price will move in both directions, sharply and quickly, before picking a sustained direction. That means you will likely be in a big losing trade within seconds of the news release.
You may be thinking that's great. With all that volatility, surely the price will swing back in your favor. Maybe it will, maybe it won't.
But there is another problem. In those initial moments, the spread between the bid and ask price is often much bigger than usual. You may not be able to find liquidity to get out of your position at the price you want.
Instead of anticipating the direction news will take the market, have a strategy that gets you into a trade after the news. You can profit from the volatility without all the unknown risks. The non-farm payrolls forex strategy is an example of this approach.
Don't choose the wrong broker
Depositing money with a forex broker is the biggest trade you will make. If it is poorly managed, in financial trouble, or an outright trading scam, you could lose all your money.
Take time in choosing a broker. There is a five-step process you should go through when deciding on which broker to use.
Don't take multiple trades that are correlated
You may have heard that diversification is good. That is arguable. Warren Buffett once said that "Diversification is protection against ignorance. It makes little sense if you know what you are doing."
If you believe in diversification you may be inclined to take multiple day trades at the same time instead of just one, thinking you are spreading your risk. Chances are you are actually increasing it.
If you see a similar trade setup in multiple forex pairs, there is a good chance those pairs are correlated. That is why you are seeing the same setup in each one. When pairs are correlated, they move together, which means you will probably win or lose on all those trades. If you lose, you have multiplied your loss by the number of trades you made.
If you take multiple day trades at the same time, make sure they move independently of each other.
Don't trade off fundamental or economic data
It is easy to get caught up in the news of the day or to form a bias based on an article you read that says economic conditions are good or bad for a particular country or currency.
The long-term fundamental outlook is irrelevant when you are day trading. Your only goal is to implement your strategy, no matter which direction it tells you to trade. Bad investments can go up temporarily, and good investments can go down in the short-term.
Fundamentals have absolutely nothing to do with short-term price movements, so don't even look at fundamental analysis while day trading. Any long-term biases can only cause you to deviate from your trading plan. Your trading plan and the strategies it contains give you an edge in the market and prevent you from gambling.
Don't day trade without a plan
A trading plan is a written document that outlines your strategy. It defines how, what, and when you will day trade.
Your plan should include what markets you will trade, at what time and what time frame you will use for analyzing and making trades.
Your plan should outline your risk management rules.
It also should outline exactly how you will enter and exit trades for both winners and losers.
If you don't have a trading plan, you are gambling. Create a trading plan and test it for profitability in a demo account before trying it with real money.
Then follow your plan precisely.