Trading is often referred to as an art form, and for those who trade by hand, it most certainly is, but if we are looking for metaphors to describe what day trading most resembles, there is, perhaps, no more accurate representation of this act than to call it warfare. You, the trader, are at war, and each trade you place is a battle in which you choose to engage. Your capital is your army and your goal is to expand your empire by winning trade battles and taking “prisoners” to put work for you as soldiers in your next battle. If that sounds like fun, it’s because it is an absolute blast, that is, until the battle takes a nasty turn in favor of the enemy. Your response to adversity will dictate how you emerge from the battle and your strategy will be the deciding factor in whether or not you create an empire, or whither away like so many others.
You Truly Have Just Two Options When Your Trade Entry Fails You
Option 1 – Cut your losses, turn tail, and head for the hills. This approach is commonly referred to as the “Stop Loss” strategy.
The idea behind applying stop losses in one’s trading is based on the belief that one may accept many small losses and live to fight another day, when conditions will presumably be more favorable. The trader who adopts this approach hopes that when this better day comes, the battle will go so well, that the losses from the previous battles will be outweighed by the gains achieved in the present trade. This is most certainly the widest held belief among retail traders and the most widely applied strategy for handling losing trades. However, this begs the question – Are beliefs that are widely held, merited based solely on the size of the discipleship? Perhaps the best metric for testing the efficacy of the most widely accepted methodology is to consider the success rate of traders applying it. A brief tour of the internet reveals that most of the researchers who study success rates of retail Forex traders, place the failure rate somewhere in the range of 90%. Of course, there are some that post higher rates and some that post lower rates, but the overwhelming evidence is that the majority of retail traders end up losing money.
Let’s be fair regarding the reasons most retail traders lose money, rather than building the trading empire of their dreams. There are many more factors that lead to poor decision making by retail traders than we can address here, but the underlying element is poorly conceived education. Much of the trading education available today, focuses almost solely on trade entry, with an emphasis on charting and chart patterns that are treated as “high win probability” propositions. Trader’s then stare at charting modules within their broker’s platform, looking for the “perfect” or “text book” trade entry patterns, like “flags”, “pennants”, “cup and handle formations”, “head and shoulders formations”, and the list goes on and on. These patterns occur on a regular basis, of course, and often don’t pan out the way the trader wants. That’s okay. Not every trade entry is going to be a winner and that’s not the fault of the trader. The problems arise when traders place more faith in the trade than is merited, and overly expose themselves with trades that are too large. In circumstances like this, a stop loss is the only realistic safety net for the trader, because the trader is not likely reserving enough equity to strategically work their way out of the bad trade with subsequent recovery trades. So, in essence, these “generals” aren’t really employing any defense in their battle plans. They are simply conceding losses, perhaps because they haven’t considered, or don’t believe that defense is truly possible.
Too many beginner traders watch stop losses add up to the point where they begin to believe that they are simply bad traders. I hope that if you find yourself in this camp you’ll take two critical points away from this post before conceding defeat.
1. You’re not a bad trader! In fact, you are more than likely a very good student, who has been given bad information.
2. There is another way to trade…
Option 2 – Carefully send in more troops (the extraction team). This approach involves a variety of strategies, but overall, has been coined “Trade Recovery” by Global Profit Technologies Inc.’ CEO and master trader Joseph Nemeth.
This, “no man left behind” option requires a plan before the battle ever ensues. It’s a measured, defensive approach that requires a trader to be as mindful, or perhaps even more mindful, of their valuable resources (their capital) as they are of the landscape in which they are engaged in battle (charts).
“Invincibility lies in the defense; the possibility of victory in the attack.”
– Sun Tzu, The Art of War
In this scenario, you, the general, view your committed trading dollars as potential POWs that you refuse to leave in enemy hands. At this point, your contingency planning comes into play as you employ hedging strategies, dollar cost averaging strategies or combinations of both, as you seek out a clear direction of the market and a way out for all of your dollars, perhaps grabbing a few “prisoners” of your own along the way. Strategic traders the world over have seen the success that is possible in formulating a strategy for defense and trading in this fashion.
There are a number of resources that are readily available, which go into great depth on applying defensive strategies like dollar cost averaging, hedging, etc., and offer guidance on how to apply these methods. Be sure to check out the bootcamp videos Joseph Nemeth has provided within this blog. These offer a wealth of insight from a position trader who has spent years developing and testing his own battle plans, and are an invaluable resource. Please also note that these videos provide a basic understanding of the methodologies at the heart of a number of strategies he’s made available through Automata FX.
Gut Check Time!
Taking on a defensive stance and sending in more troops when the battle has turned against you requires a level of intestinal fortitude that many do not possess. Perhaps the biggest critique of trade recovery comes from those who see drawdowns as unpalatable, and large drawdowns as completely unacceptable. This is entirely understandable. Newbies to this method of trading tend to get very nervous when they see more and more of their trading capital join the fight, especially when they consider that they could have simply lost just a few “troops” and moved on to a new battle. This is because many trading newbies view their capital not as a resource needed to win the fight and grow, but as a necessity that cannot be risked. Those who have successfully employed these techniques in the past, however, grow increasingly calm and resolute with each drawdown, as they gain more and more confidence in their strategy, and less fearful of the potential risk of losing money. These methods require not only sound logic, but patience and faith and most importantly, a complete lack of emotion. Traders who wish to employ these techniques must do two things.
1. Traders must be patient and responsible enough to either take their time as they choose the parameters of their strategy, or, if using a pre-built strategy, spend an adequate amount of time reviewing the parameters of the strategy in order to understand how the strategy will react to various market conditions.
2. Traders must truly understand themselves so they have a realistic view of their own appetite for risk. Yes, we all trade/invest with the intention of making money, not losing money. Indeed, that is the intention in trading both with stop loss strategies and with defensive strategies. Nearly every trading education website, broker website etc. notes that traders should not trade with money that they cannot afford to lose. This is, in part, because trading with money that one cannot afford to lose is a recipe for emotional decision making, which is disastrous in trading. For instance, if one lacks patience over longer term drawdowns, one may choose to accept the drawdown as a loss before the recovery has had the chance to succeed. If drawdowns make a trader uneasy, then the trader is either trading with more money than the trader can realistically afford to be working with, or perhaps the trader shouldn’t be trading in the first place. Drawdowns can tell you a lot about your appetite for risk. It is far better to evaluate your tolerance beforehand, than while you are waiting for your strategy to pull out of the drawdown. Every trader owes it to themselves to evaluate their own expectations and financial resources before choosing to embark on the adventure that is Forex Trading.
The Choice is Yours
Was Sun Tzu overzealous in suggesting that good defense can make one invincible? Are traders who employ defensive strategies foolish for believing that the concepts offered by the World’s most illustrious and quoted war strategist may have merit in the everyday battles fought on the field of the Forex market? Ultimately the choice is yours. While there are plenty of excellent traders who can, and often do employ stop-losses as part of their strategy, there are many more who suffer from the accumulation of losses in the long run. Carefully and honestly evaluate your own experience and if possible, review other trading strategies as they trade in real time. What can the trading experiences of others tell you about your own appetite for risk? Could you see these methods working for you, or better yet, could they inspire you to build upon your own trading techniques? The Forex battle rages on. Is it time to start employing some defense/rescue missions in your battle plans?