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His study on Prospect Theory attempted to model and predict choices people would make between scenarios involving known risks and rewards.
The findings showed something remarkably simple yet profound: Why should we then act so differently? Taking a purely rational approach to markets means treating a 50 point gain as morally equivalent to a 50 point loss. We need to think more systematically to improve our chances at success. Avoiding the loss-making problem described above is very simple in theory: But how might we do it concretely? When trading, always follow one simple rule: This is a valuable piece of advice that can be found in almost every trading book.
If you target a profit of 80 pips with a risk of 40 pips, then you have a 2: If you follow this simple rule, you can be right on the direction of only half of your trades and still make money because you will earn more profits on your winning trades than losses on your losing trades. What ratio should you use? It depends on the type of trade you are making. We recommend to always use a minimum 1: That way, if you are right only half the time, you will at least break even.
Certain strategies and trading techniques tend to produce high winning percentages as we saw with real trader data. We will discuss different trading techniques in further detail in subsequent installments of this series.
Remember, it is natural for humans to want to hold on to losses and take profits early, but it makes for bad trading. We must overcome this natural tendency and remove our emotions from trading. The best way to do this is to set up your trade with Stop-Loss and Limit orders from the beginning. Since they practice good money management, they cut their losses quickly and let their profits run, so they are still profitable in their overall trading.
Our data certainly suggest it does. We use our data on our top 15 currency pairs to determine which trader accounts closed their Average Gain at least as large as their Average Loss—or a minimum Reward: Were traders ultimately profitable if they stuck to this rule?
Past performance is not indicative of future results, but the results certainly support it. Our data shows that 53 percent of all accounts which operated on at least a 1: A mere 17 percent. T raders who adhered to this rule were 3 times more likely to turn a profit over the course of these 12 months—a substantial difference. Whenever you place a trade, make sure that you use a stop-loss order. Always make sure that your profit target is at least as far away from your entry price as your stop-loss is.
You can certainly set your price target higher, and probably should aim for at least 1: Then you can choose the market direction correctly only half the time and still make money in your account.
The actual distance you place your stops and limits will depend on the conditions in the market at the time, such as volatility, currency pair, and where you see support and resistance. If you have a stop level 40 pips away from entry, you should have a profit target 40 pips or more away. The best way to avoid such a fate is to never suffer a large loss.
The art of trading is not about winning as much as it is about not losing. By controlling your losses, much like a business that contains its costs, you can withstand the tough market environment and will be ready and able to take advantage of profitable opportunities once they appear.
Swinging for the Fences Most traders begin their trading careers, whether consciously or subconsciously, by visualizing "The Big One" - the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. Large losses, as the following table demonstrates, are extremely difficult to overcome.
It's impossible to avoid disaster without trading rules — make sure you know how to devise them for yourself. It is impossible to avoid losses completely, but there is a systematic method you can use to control them.
Consulting with a qualified accountant or tax specialist can help avoid any surprises and can help individuals take advantage of various tax laws, such as marked-to-market accounting recording the value of an asset to reflect its current market levels. Since tax laws change regularly, it is prudent to develop a relationship with a trusted and reliable professional who can guide and manage all tax-related matters.
As such, traders should try to avoid becoming overly emotional about either wins or losses, and treat each as just another day at the office. As with any business, forex trading incurs expenses, losses, taxes, risk and uncertainty. Also, just as small businesses rarely become successful overnight, neither do most forex traders. Planning, setting realistic goals, staying organized and learning from both successes and failures will help ensure a long, successful career as a forex trader.
The worldwide forex market is attractive to many traders because of its low account requirements, round-the-clock trading and access to high amounts of leverage. When approached as a business, forex trading can be profitable and rewarding.
In summary, traders can avoid losing money in forex by:. Take the Time to Find a Reputable Broker The forex industry has much less oversight than other markets, so it is possible to end up doing business with a less-than-reputable forex broker.
Use a Practice Account Nearly all trading platforms come with a practice account, sometimes called a simulated account or demo account.
Keep Charts Clean Once a forex trader has opened an account, it may be tempting to take advantage of all the technical analysis tools offered by the trading platform. Protect Your Trading Account While there is much focus on making money in forex trading, it is important to learn how to avoid losing money. Start Small When Going Live Once a trader has done his or her homework, spent time with a practice account and has a trading plan in place, it may be time to go live — that is, start trading with real money at stake.
Use Reasonable Leverage Forex trading is unique in the amount of leverage that is afforded to its participants. Keep Good Records A trading journal is an effective way to learn from both losses and successes in forex trading.
Understand Tax Implications and Treatment It is important to understand the tax implications and treatment of forex trading activity in order to be prepared at tax time. The Bottom Line The worldwide forex market is attractive to many traders because of its low account requirements, round-the-clock trading and access to high amounts of leverage. In summary, traders can avoid losing money in forex by: