Trading the financial markets, whether by way of fundamental or technical analysis, is not so much about “predicting the future”. In fact, no one can really do that. Many traders, while complaining about the “lagging” nature of some indicators, mistakenly explain that these lagging indicators are of no value because they are derived from historical data. The ridiculously simple truth  is, quite plainly, that we have no alternative! Only historical data is available; there’s no such thing as “future data”! Whether you’re using technical or economic indicators, all analysis is derived from historical data.

All forecasts are a matter of probabilities, not certainties. What we can do, at best, is to use a reliable combination of analysis tools (technical or economic indicators) to attempt forecasting the future in a probabilistic way. This is why all trading and investment decisions must come with a plan for dealing with losses, i.e. those scenarios where even high-probability forecasts turn out wrong (nothing in the future is zero-probability or 100% certain). Many traders and investors have plainly forgotten or willfully disregarded the need to do that. Winning traders and investors are those who can take losses when their views are proven wrong, while ensuring that the gains received when they are right are larger than the losses incurred when they are wrong. The philiosophy of successful trading is really as simple as that.

Many traders and investors often experience the frustration of the market going against them “most of the time”. Many people say that “it always goes down whenever I buy, and it always goes up whenever I sell!” Is it a matter of bad “luck”? Or are there some very basic reasons why most traders lose money?

Without a highly systematic and controlled way of engaging the markets, the markets are always rigged against us. It is not unlike going to a casino, where your chances of making money in the long term are practically zero. In the casinos, all the games are rigged against us in the sense that they always have an edge over us. An “edge” is simply a statistical advantage that ensures that you will lose money if you stay long enough in the game. In trading or investing, that “edge” is largely due to many weaknesses in the human psychology, and the interactions between market movements and human emotions. Removing that edge is largely dependent on mastering the psychology of trading, which is far more crucual than sophisticated technical analysis.

Forex trading is often perceived as a very enticing get-rich-quick activity.  Many online and offline advertisements seem to suggest that we can build a superhighway to financial freedom via clicking the mouse a few times every day. Certainly, I am not against a healthy motivation to get some good education in trading the Forex market. Indeed, in my training workshops, I always feel compelled to shed light on why mastering the Forex market has been such a challenge for most people, and how aspiring traders should re-condition their minds to change many counter-productive belief systems which cause most to fail in this pursuit.Within the community of aspiring traders, there is a prevalent “Holy-Grail’ mentality which causes many traders to believe that once you identify a winning formula, you are all set to consistently take money out of the market. For the vast majority of traders, the constant search for such a “formula” becomes a very futile and endless journey, for they never learn the real reasons underlying the successes and failures of traders.  

As soon as we attain a certain level of competency in studying chart patterns and indicators, the most crucial determinant of trading success lies in the ability to master ourselves. As such, I always advocate spending more time on one’s mental strategies, rather than endlessly pursuing new and sophisticated analytical tools and indicators.

Most traders are very preoccupied with making their entry points as ideal as possible, using elaborate screening mechanisms (including all kinds of fanciful indicators) to help them develop supposedly superior entry techniques. However, it is worth noting that despite more elaborate and sophisticated entry techniques being developed over the years, the overall success rates among traders have remained largely unchanged.

One main reason for this phenomenon is that people usually do not have any idea when they are going to get out of a position they have entered into. In fact, a trading system is hardly a complete one if a well-defined exit plan is not available. A systematic exit plan is needed to ensure you know how to take profits and cut losses. Quite simply, the cardinal principle in trading, i.e. to cut losses short and let profits run, is all about having a good exit plan.

Most people ignore or underestimate the importance of exit strategies. It is no wonder traders continue to struggle to make money despite being so knowledgeable about all kinds of indicators and entry techniques.So, why do people underestimate the importance of exit strategies? I suggest that selecting entry points gives us a sense of being in control, which is largely an illusion. In contrast, exit strategies involve trading actions (i.e. getting out of trade positions) which are not immediately executed when a trading opportunity is first identified. The excitement is the strongest at the point of entry, whereas exits involve actions which can be delayed indefinitely. As such, there is naturally less interest in exit techniques.If you think carefully about what trading really is, you will realize that the outcome of every trade taken is the result of price movements which occur between your entry and exit points. Traders doing the same trade by using the same entry setup (leading to the same entry level) can produce vastly different outcomes due to different exit levels. Many traders allow their emotions to dictate their exits, leading to bad trading performance regardless of the elaborate and sophisticated entry techniques they use.Statistical research shows that exit strategies account for a greater part of overall returns than entry techniques. So, it is certainly in your interests to pay attention to how you take profits and cut losses.

The age-old axiom of trading is that we are to “cut our losses short, and let our profits run”. I’ve realised that what we tend to do best is the exact opposite! If we don’t condition ourselves to overcome our most natural trading insincts, chances are that we tend to “cut our profits short, and let our losses run”. Indeed, latest research in behavioral finance has revealed what traders and investors of all ages have always done, i.e. the fact that we tend to take more risk with losing positions, and become very risk-averse with winning positions. This “asymmetry” or inconsistency causes us to be unwilling to take losses and also to take profits too soon. Traders are unwilling to let a trade hit a stop-loss point, because humans are conditioned to avoid immediate pain; moving (or even removing) a stop-loss order allows one to delay the pain of taking a loss, and hopefully avoid it! With regard to profit-taking, many traders fear that a profit might “evaporate” away and take it too soon.  This habit gives the immediate relief or pleasure of “locking” in profits.

If you think about it carefully, these two habits will guarantee that our profits are not sufficient to pay for our losses. Even with a high win rate, you could end up losing money!!! The right way to trade is to ensure that our profits are , on average, bigger than our losses. This is why many winning traders can be very profitable despite having a modest win rate of only slightly more than 50%. Winning traders really practise the basic principle of letting our profits run and cutting our losses short!

All traders who use some form of technical analysis (i.e. chart-reading) rely on the underlying rationale that there are patterns embedded within the seemingly random ups and downs in the price movements. Somehow, we have to believe that there is order within chaos. Certainly, the existence of such order is what we rely on in order to have a trading method which gives us an edge over the market.

However, all too often, our attempts to discover patterns are overdone. The human mind is created to recognise patterns within chaos, causing us to be too eager and hasty in coming to conclusions about certain patterns on the charts. As we eye-ball the historical charts, we will certainly be able to to find many profitable trades based on some technical conditions, thereby leading us to arrive at a strategy. The thing is that our eyes are under the influence of selective perception, i.e. we tend to see the trades that work, and visually bypass those that don’t. The technical analyst is often deluded by illusions of order.

In this way, the trading rules that one arrives at tend to be too simplistic. The market is so dynamic that we often need to apply some filters to the trading rules; such filters cannot be clearly seen in our “visual backtesting”.

Another thing to note is that correlation does not imply causality. This means that the often-noticed phenomenon that two currency pairs tend to move in tandem does not imply that movements in one of the pairs “causes” movements in the other. Any strategy based on assumptions of causality cannot work consistently.

We should be reminded that although there are patterns within the ups and downs of crowd psychology in any liquid market, such patterns do not exist like they do in an exact science (e.g. laws of physics), and are therefore still full of randomness. This is the reason why we should make allowances for losses in all trade decisions (regardless of how we filter trading signals); such losses occur when the “randomness within patterns” works against us. The fact that such losses occur from time to time does not mean that we don’t have an edge over the market. Having an edge over the market means that in the long run, the wins will more than cover the losses. Much of the diffilculty in trading is learning to accept this simple principle.

Too many traders simply overlook or gloss over the importance of discipline and stringent risk management. When we consistently keep to the rules despite losses, and keep losses to a minimum via stringent risk management, any simple strategy that gives us an edge will be profitable in the long run.

I’ve often realised that trading need not be very complex, as long we focus on the things that really matter. I believe the vast majority of traders spend too much mental energy and time looking for trading strategies that supposedly give them high success rates. When you tell them that successful trading is largely about trading psychology and risk control , and that many strategies will be profitable if you take care of these two important elements, they will say something like, “Ya…I know that basic stuff already….isn’t that what everybody is saying?”

The truth is that the majority of them haven’t really grasped the importance of trading psychology and risk control. They know it intellectually, but are far from internalising it to an extent where it naturally guides their trading behavior. In fact, I recently did an experiment by backtesting a “strategy” that uses some form of random entry, but rigidly manages the risk per trade (keeping it at 2% of the account). I realise that such a “strategy” outperforms most people who keep running after sophisticated strategies.

This experiment shows that in order to achieve consistent success in trading, position-sizing and exit rules are more important than entries. A strategy that only tells you about entry points is not a strategy at all. Position-sizing ensures that your trades are not too small, nor too large. Exit rules determine when you should get out of the trade, whether at a profit or a loss. In this way, your risk is always kept to a small percentage of your account balance in every trade that you do.

In addition, the hard part of trading, which most people fail in doing, is to think in terms of probabilities, which work out in the long run. Such a mindset ensures that we are not so short-sighted as to be concerned only about making every trade work. Our psychological tendency to “make every trade work out” naturally makes us very short-sighted and “cut our profits short, and let our losses ride”! We tend to be too conservative with profits; being fearful that the profits will evaporate away, we take them too soon. Also, we tend to be too risk-seeking with losses, because we’re not willing to realise the losses, and somehow “hope” that the losses will turn into profits! Overcoming such a behavioral pattern is arguably the most important mental exercise every trader must undergo.

When we overcome the psychological biases that so often sabotage our trading success, we avoid doing the “most comfortable thing” when facing winning or losing trades. We then realise that it is the long-run distribution of profits and losses (and their relative sizes) that really matter.

Having been trading the dynamic currency markets for quite a while, I’m convinced that market action is indeed human nature in action. According to conventional thinking, the Forex market (and any market for that matter) is driven by significant events, whether economic or political. As such, we tend to anticipate a certain outcome in the market as a result of a certain event, only to realise that the outcome could be contrary to conventional logic. For example, the US economic stimulus package could be seen as good news for the US economy, and thus motivate some people to buy the USD. However, the USD could also decline as a result of the same news event. The thing about economic events is that they can be interpreted in different ways to explain opposing outcomes. The financial media often attributes opposing market moves to the same news event!! For example, on a certain day you may read something like “The USD strengthened due to  Economic Event X”. The next day, when the USD weakens, you could read something like, “The USD weakened due to Economic Event X”.

So, is it the news events that drive the markets? I would say that it is the market’s response to the news events that drives the market. What difference does it make? A whole lot of difference!!! The market’s response to news events is very often irrational, and also very often happens before the actual event!! Many traders try to make sense of how a certain event will impact the market, after the event has occurred. This attempt is pretty much like shooting a moving target, because there are always 2 opposite ways the market will respond to the same event.

My trading style focuses primarily on identifying patterns in the ebb and flow of crowd psychology, which is truly the “engine” that drives the market, resulting in the trends (short-term and long-term) that we see on charts. Almost all the time, I realise that trading successfully relies a lot on going against the crowd psychology, which entails making decisions which are contrary to our natural human instincts. This, to me, is the greatest challenge all traders face, regardless of what kind of trading strategies they use.

I’ve often said to my trainees that Forex Trading is one of the very few ways by which one can start with a relatively small capital and achieve financial freedom by maximizing the power of compounding. We’ve all heard of people who mutilply their accounts manifold, and many wonder how these people achieve their million-dollar net worths through the business of currency trading.

In the light of the current financial crisis, many people have lost faith in all forms of investments. So, when you tell them you can generate a consistent monthly return of 10% or more, they think it’s unrealistic.

To me, trading is almost the only way to get this kind of returns regardless of the economic climate. A “10%-per-month” goal does sound hard for some people, but if you break this goal down to trade-by-trade goals, you start to see how realistic it is.

Contrary to popular beliefs, you don’t need to do too many trades. Personally, I find that aiming for about 10 trades a month gives me a comfortable way trading the Forex market. I don’t need to be stressed about doing too many trades. It also means you are more selective about doing trades, which in turn means that your success rate should be higher. A 70% average success rate can make you very rich over time!

Suppose you do 10 trades a month, and 7 of them are winning trades, and the other 3 are losing ones. If each winning trade gives you a return of 3% of your account size, and each losing trade results in a loss of 3% of your account size, the net result of your 10 trades in the 1-month period is a return of about 12% of your account! Remember, this is assuming a 1:1 risk reward ratio in every trade. In some cases, your profitable trades will lead to a return of more than 3%.

So, you see, it is discipline that allows this process to be repeated over and over again - trade after trade, week after week, month after month, and even year after year. That’s why some traders can multiply their capital manifold with sheer discipline. A monthly return of 10%, when compounded, will triple your capital in 1 year, and mulitply your capital by 10 times in 2 years! Such goals seem far-fetched at first sight, but when you break them down to monthly goals, and even trade-by-trade goals, you start to see how discipline and perseverance will make the small goals snowball into big goals!

We naturally don’t like to talk about losses. Let’s face it! Despite all the talk about managing our trading psychology, there’s a part of us that wants to win every single time! Even I, as a seasoned trader, sometimes have to acknowledge this part of me.

The fear of loss tends to manifest itself in two ways.

1) After entering a position, many traders who refuse to lose will move their stop-loss points very far away from their entries. As such they may lose more than they should in the end.. Some traders even go to the extent of not placing a stop, believing that the price will somehow come back and hit their profit targets. The problem with doing this is that the process of waiting for that to happen can be very agonizing. It may take days, weeks, or months! In the meantime, your losses can increase very quickly! It’s certainly detrimental to your trading psychology!

2) Another way in which the fear of loss manifests itself for some people is that the trader becomes overly conservative. Everytime a trade opportunity appears, such a trader becomes very hesitant, and is very worried about whether the trade will turn against him if he enters it. As such, very often he misses many trade opportunities.

Losing trades generally set in motion a series of emotions in us, e.g. denial, anger, depression and finally acceptance. The goal is to get to the last stage, i.e. acceptance, as quickly as possible.

The more emotionally controlled you are, the less likely you are to be overwhelmed by denial, anger and depression. You will not allow yourself to magnify the impact of any particular loss. You’ll know that in the grand scheme of things, this particular loss doesn’t mean much. You’ll know that it’s fine to lose when you followed the rules (On the contrary, if you keep winning by breaking the rules, you should worry instead of congratulate yourself!).