The Tycoon Report

Forex Trading Methods: Finding the Right One

Thursday, November 12, 2009 | Bill Poulos

A Special Note from The Tycoon Report: As a free investor-education newsletter, we are always on the lookout for opportunities to round out your education with different strategies and approaches.

Today, we are pleased to bring back Profits Run Founder Bill Poulos, who talked with you last week about why trading forex now beats the stock market. In this second part of a four-part series, he'll talk with you about identifying the best methods to trade the foreign-exchange market.

To get even more information on forex, be sure to visit the link at the end of this article.

Forex Trading Methods: Finding the Right One

Today I want to take a few minutes to talk about foreign exchange (forex) trading methods, because I believe the market is overwhelmed with new systems and robots almost daily, which means traders have little chance of being able to identify the right ones to use, the best-performing or the most-educational.

With so many methods, systems and automated programs, how do you select the one that is best for you, or the one that gives you the best opportunity for forex trading success?

I've developed a simple set of rules to follow when evaluating a forex trading method, course, system or program, and today I want to share them with you.

4 Forex Rules of the Road

First and foremost, any forex trading method you consider must be complete. By complete, I mean the forex trading method must teach you the following:

1. The precise conditions under which you can consider a forex trade to be entered into. These are known as the "setup" conditions and refer to the technical indications (usually) that a forex trade possibility exists.

2. The exact point at which you would enter into a forex trade (price). This refers to the entry point (or entry rules) and means the price at which a forex trade would be executed.

3. Rules for establishing initial and ongoing stop-loss marks for an open forex trade. As part of risk management, it is imperative -- especially in forex -- to have stop-losses ALWAYS in place. If a forex trading method or forex trading system does not teach or define these, you should abandon it. Without effective stop-loss management, you can be easily wiped out in a single forex trade, should the forex market move against you.

4. The exact points and an effective strategy for exiting a forex trade. Unlike stocks, you will rarely, if ever, find yourself holding a forex pair position in the forex markets for extended periods of time. Therefore, it is also important that a method teach you a strategy for exiting a forex trade once that trade has become profitable.


Combined, these four elements will help you to eliminate chance by streamlining your forex trading decision-making process.

Without any of these, no forex trading method, system or program should be considered because, in each individual case, forex traders will be exposed to steep losses or taking poor forex positions.

Keep in mind, every setup will not execute into a forex trade, nor should every forex trade be taken. Combined, these rules will help to protect you both in evaluating a method for its use and in executing the method when trading forex.

Risk Management

Risk management is perhaps the area where 95% of forex traders make mistakes and lose money.

Managing risk is about reducing your losses AND about protecting trade capital by employing specific strategies to accomplish each of these simultaneously, which I talked about last week.

What do I mean by that and why is it important?

• First, most forex traders make simple trading mistakes: They take too large of a position and expose themselves to serious and steep losses should the markets move against them.
   
• Second, they fail to protect their ENTIRE account by allowing ONE trade to put their full account balance at risk.

Here's a quick (and perhaps extreme) example:

Suppose a forex trader has a $10,000 account balance. The forex trader takes a five-standard-lot forex trade on the EUR/USD pair (i.e., buying the Euro and simultaneously selling the dollar against it).

The forex trader now has at least $5,000 "margin" at risk (or 50% or more of the forex trader's account balance).

For every 1 point that this forex trade moves against the forex trader, he or she loses 1/2% of the total account balance.

Don't Make This Mistake

At first glance, that may not seem like a steep loss. However, should the forex trade move a total of 50 pips against the forex trader, and the trader subsequently exits the position, the total loss would be an INCREDIBLE $2,500!

That's 25% of the trader's account balance. This is poor risk management, and it frequently leads to complete wipeouts of forex trading accounts.

How did we calculate that loss? One pip for the EUR/USD pair is equal to $10 (on a standard-lot trade). A 50-pip loss equals a monetary loss of $500; and remember, our example forex trader had traded five standard lots -- for a whopping loss of $2,500!

Instead, any trading method should teach you very specific guidelines for incorporating money management and risk management into every forex trade you take.

Keeping More Money by Lowering Your Risk

Money management should involve the distribution of a forex account among the various trades you take. For example, forex traders should never trade their entire account on a single trade, and should rarely have more than a few open positions. By utilizing multiple positions, you distribute the risk among each of the forex trades you have taken.

Risk management should involve the maximum risk in any SINGLE forex trade, and should limit the impact of a losing forex trade on the trader's account balance.

Here are two quick examples:

Example No. 1

Money management: A theoretical forex trader takes four separate one-lot trades on four separate pairs.

Assuming here that each of the pairs have a pip value of $10 on a standard lot, then the total amount of the account being margined across all four trades is about 40%. (It may be higher, depending upon the actual pairs traded.)

With proper stop-loss management, however, in conjunction with risk management, it is UNLIKELY that the forex trader would incur a complete 40% loss.

Carrying forward to risk management: In each of the theoretical forex trades above, the forex trader risks no more than 2% of the trader's total account balance on each forex trade.

That means a maximum loss of $200 per forex pair traded if ALL FOUR trades are stopped out. Total loss in this case would be $800 -- a much-more-recoverable scenario than the $2,500 in the first forex trade example.

Furthermore, risk management has the capacity to make loss recovery easier. For example, in the first case, where the Forex trader lost $2,500, the trader would need a nearly 250% gain on their next trade to recover the lost value on the first trade.

Example No. 2

In this example, however, the forex trader would need only an 8% gain.

A second part of risk management not typically discussed in poor trading methods is protecting gains.

Though this begins as a discussion on exit-strategy rules, it is also an element of risk management.

Once a forex trade turns profitable, it is imperative that the forex trader manage the gains with smart stop-loss management. The worst thing you can do is allow a profitable position to reverse and become a losing position.

Thus, managing risk extends to the protection of gains on a forex trade, just as it does protecting against deep losses.

Therefore, in considering any trading method for use in your forex trading, you must ensure that risk management is not only discussed, but clearly explained in conjunction with the use of the trading method.

If risk management is not present, unclear, or not specific to the trading method, you should avoid using that trading method.

End-of-day Trading

The last step in determining whether a forex trading method should be considered, is the amount of time it requires a forex trader to use it on a daily basis.

The dirty secret in the forex markets is that most people OVERTRADE. This happens because forex traders are widely taught that the only way to succeed in the markets is to day-trade.

The dirty "secret" is that, if a forex trader can't make money trading forex on an end-of-day basis,he or she is unlikely to be any more successful day-trading forex.

In fact, growth among retail forex traders is accelerating -- these are people who currently have "day" jobs. There is no likelihood that these traders have the time to watch the forex markets 24 hours a day.

What happens if the traders fall asleep and miss putting in a protective stop order? Or miss an entry point?

I advocate trading forex on an end-of-day basis to eliminate the stress and time pressure to make instant decisions on order entry, immediate placement of stop orders, and constant "watching" of the markets.

Combined with utilizing technical indicators, end-of-day trading allows forex traders to spend more time looking at the "big picture" -- is there really a trend? Is my method "right"? Are my numbers and calculations correct?

And, they can do so in the quieter trading hours following the New York close (5 p.m. Eastern Time).

Here's a brief example:

The EUR/USD pair, from March 2009, has shown a strong move from the 1.2600 range to 1.3000 -- a 400-pip gain, which took about seven days to complete and should have been captured by a good end-of-day trading method.

However, that same chart shows more-extreme fluctuations as the price ranged sideways in a 200-pip channel -- if a forex trader is trying to day-trade in that channel, the trader can quickly find themselves on the wrong side of a trade in more-extreme short-term volatility.

Forex traders who do not have the time to commit to managing their trades and monitoring the markets are precisely the traders for whom an end-of-day forex trading method based on technical analysis is best-suited.

Technical Analysis

I believe the best forex trading methods are based on technical analysis, without being 100% mechanical or automated.

As you already are aware, there are two primary forces acting in the forex markets:

• Fundamental data, which include such indicators as balance of trade data, money supply, interest rates, economic and financial reports, etc.; and
   
• Technical data, which include such indicators as moving averages, average directional movement, stochastics, etc.

So, why should a forex trading method be focused on technical indicators?

First, attempting to trade on fundamental data requires you to be available on a real-time basis at whatever hour of the day or night that the news impacts the markets.

And, you must be able to act on that news before (predictive) or at the instant thousands of other forex traders do (reactive). Otherwise, you will have missed your opportunity.

Trading on fundamentals, as well, is less about the actual data itself and more about the market's reaction to that data.

Technical analysis, however, allows the trader more time to make a smart decision. Utilizing technical indicators means the fundamentals are already reflected in the price of the market at any given instant.

While this means you are working more often with slightly lagging indicators, the advantages to using a forex trading method based on technical analysis mean that you spend less time identifying potential trades.

And, when you have identified a trend and look to enter a trade, you have much more data to support the trend's existence than if you are simply trading on the "news."

Furthermore, by using technical analysis and applying it through a trading method, you can trade the markets on your own terms -- when you want to trade and how you want to trade them -- without needing to grasp the minute details of what fundamental reports "really" mean.

Forex trading is littered with methods, systems and automated programs -- the challenge is finding the right one for you. Next, let's touch upon several of the keys to identifying a good trading method.

Finding the Forex Method for You

First, a good trading method will avoid using too many technical indicators, or, avoid using the wrong technical indicators.

The importance here is simplicity. Any method that weighs a forex trader down with too many indicators is more likely to confuse the forex trader, or, create conflicting trade potential.

So, one key to a good method is the use of a few indicators that, together, can identify a strong trade opportunity. We have found it rarely requires more than three or four indicators working together to accomplish this. If a forex trading method is using more than that, you should be cautious.

As well, any method should not be 100% mechanical. By "mechanical," we mean no room for market interpretation.

A good trading method will allow the forex trader the flexibility to see the larger picture -- for example, is a forex pair in an extended downtrend? If so, is now the right time to buy an uptrend?

A mechanical system may "signal" buy -- but a forex trader who doesn't apply the bigger picture or direct interpretation of what's happening in the market may blindly follow such signals and be at risk of significant loss.

A good method should use simple indicators to identify a trending forex pair, and use them in such a way to provide higher-probability profit potential and lower risk.

Last, a good forex trading method should provide objective rules that help the forex trader establish trading discipline. On discipline, we're referring to the actions of trading -- buying, selling, setting stops, etc.

If too many decisions are left to the forex trader, they are too likely to be indecisive, afraid or unable to pull the trigger on their trading actions. Therefore, it is imperative that the rules of a trading method be simple and easy to follow, but allow for some interpretation about entering a trade.

With these additional keys, a forex trading method is more likely to provide a successful trading experience for the forex trader.

Good Trading,




Bill Poulos
Founder
Profits Run