Why wait? – Analyzing the Power of Patience
Why wait? – Analyzing the Power of Patience
Have you ever found yourself making statements like,
“I’ve got to make some money today.”
“I’ve got to get in this trade.”
“I’ve got to make a move.”
“I need to find some action.”
Is any of this sounding familiar?
For a lot of traders the urge to ‘get in the game’ can be overwhelming. An even more powerful urge can be watching a trade you are in go sideways and wanting to DO something about it. For minutes, hours even days you must sit and wait for the market to either move in your favor, or worse, against you. During such times a traders internal dialoged can be going crazy as he or she struggles with what to do.
You see, we must DO something right? If we’re just sitting at our computer and nothing is happening we must be doing something wrong….right? If there is no action in our trade that means we’re missing the action somewhere else doesn’t it?
Many, many traders get involved in FOREX with dreams of quitting their job, working from home and possibly making more money than they ever thought possible. We can encapsulate all of these ambitions into one simple desire, freedom. Freedom from a job that require us to keep regular hours. Freedom from a boss who tells us what to do and how to do it. Freedom from the fear of losing that job and having nothing. And most of all, freedom from financial stress.
The idea of ‘calling your own shots’ and ‘making your own rules’ is enticing to most traders. We are free thinkers, tend to be fairly risk tolerant, and tend to view money as a tool rather than a commodity. That’s why it might be strange to learn that these same traits can be extremely detrimental to your account balance.
You see, trading (when done correctly) can be quite boring. Sure working in the pits on an exchange or on a high risk trading floor can be exhilarating, but there is nothing exciting about watching your trade move sideways for minutes, hours or days. It takes a great deal of discipline to trade your system day in and day out. Trading requires you to be unemotional. Nothing kills an account quicker than an ego.
But these traits fly in direct opposition to our stated goal….freedom. When we fix ourselves to a set of rules and conditions we MUST follow, we are no longer free. Discretion (read ego) must be set aside. How many of you have purchased a trading system or EA only to second guess it at every turn? The desire to add your own bit of ‘human element’ (read ego) undoubtedly led to loss after loss. Maybe the system was junk to begin with, but how could you really know?
Another heavy contributor to our desire to trade comes from this concept of “time for dollars”. For many of you, trading is not your first carrier. It certainly wasn’t mine. Some of you have spent 10, 15 even 20 years in a carrier before moving into trading. For a large chunk of your adult life you equated ‘hours worked’ to ‘dollars paid’. The overwhelming desire to trade often comes from that unreasonable expectation that we must DO something in order to EARN our paycheck. We MUST trade. Because if we simply sit in our chair and watch the market without trading we have not EARED any money.
Traders, we are not in the ‘got to make money’ business. Our compensation is not determined by how many trades we take, or how long we spend in front of the computer screen. We are PAID (if you must use that term) for our discipline and sound decision making. This means that some weeks we’ll make nothing. On occasion we will lose money. But over time we are profitable because we have a plan we know works and we have the discipline to follow it.
People who have run businesses have an easier time understanding this than those that have not. You see, when you run a business there are days, weeks, even months when you won’t make one penny. You may spend 18 hours a day trying to build that business into something great only to see those efforts lost in the result. If we stop thinking in terms of Hours Worked = Dollars Paid we can shift our focus and our expectations from one of, “I have to trade.” To something more profitable like, “I have got to stay disciplined.”
Ask yourself a simple question today. Do I have an urge to trade because of some unreasonable expectation I have been putting on myself? If the answer is yes there are some simple things you can do to refocus your goals and change your beliefs. You have already begun to ask yourself more empowering questions, so you are one step closer to discovering more empowering answers.
A Mathematical Approach to Eliminating Emotions
Most traders spend countless hours looking for that magical combination of indicators that will reveal the “holy grail” of trading strategies. Obviously, the goal is to find a winning strategy, but more oftentimes than not "winning" is misconstrued into trying to find a strategy that wins a high percentage of trades. After all, winning a trade means making money, and losing a trade means losing money, right? Don't be so sure about that.
Like many of the seemingly obvious components that go into creating a great trading plan and becoming a great trader, what we think seems logical in reality is what is holding us back.
Along with other ways to think in terms of probabilities, the following is an example of something I deeply believe needs to be not just simply understood, but ingrained into the subconscious of our trading psyche (if through nothing more than repetition) in order to ultimately eliminate emotions for every single trade we place. This may perhaps be the most difficult aspect of becoming a true professional trader, but a trait that one simply must have to stand any chance of survival—both financially, and psychologically.
Being a profitable trader is not just about winning percentages. In other words, you can earn positive returns without winning most, or even a majority, of your trades! It’s all about risk vs. reward. If your strategy allows you to identify trading opportunities that offer more reward than risk, then even a 50% winning ratio could yield a significantly positive return over time.
For example, let’s assume a $10,000 trading account where 10 trades are placed, and $100 (1%) is put at risk for each trade…
If risk-to-reward is 1-to-1, then a 50% win ratio will result in a “break-even” return…
[10 trades placed] x [50% losers] = [5 losses] x [$100] = [$500 loss]
[10 trades placed] x [50% winners] = [5 wins] x [$100] = [$500 profit]
[$500 profit] – [$500 loss] = [$0]
If risk-to-reward is 1-to-1.5, then the same 50% win ratio will result in a positive return…
[10 trades placed] x [50% losers] = [5 losses] x [$100] = [$500 loss]
[10 trades placed] x [50% winners] = [5 wins] x [$150] = [$750 profit]
[$750 profit) – [$500 loss] = [$250 profit]
In terms of percentage return, this second (profitable) example would result in a 2.5% return based on the starting account balance (total equity) of $10,000 after just 10 trades. This, of course, is the case when just 1% of total equity is put at risk. If 3% ($300) is put at risk (a rather high amount to most veteran traders), then this same example (same track record) would yield a 7.5% return. . In other words, greater profits are achieved based on the exact same performance…
[10 trades placed] x [50% losers] = [5 losses x $300] = [$1,500 loss]
[10 trades placed] x [50% winners] = [5 wins x $450] = [$2,250 profit]
[$2,250 profit] - [$1,500 loss] = [$750 profit]
Conversely, a high winning percentage (which typically necessitates a bigger margin for error, or greater risk) may actually result in smaller, less profitable returns over time. This occurs when the average risk is higher than the average reward. For example, using the same hypothetical $10,000 account that’s risking 3% ($300) let’s assume an 80% win ratio with an average risk-to-reward ratio of 2-to-1…
[10 trades placed] x [20% losers] = [2 losses x $300] = [$600 loss]
[10 trades placed] x [80% winners] = [8 wins x $150] = [$1,200 profit]
[$1,200 profit) – [$600 loss] = [$600 profit]
So the trader that boasts an 80% win ratio may actually be less profitable than the trader with a seemingly unimpressive 50% win ratio. So the question is…do you want to be right, or do you want to make money? Believe it or not, even negative returns are possible with a higher winning percentage when risk far outweighs reward, so make sure to factor this in when performing due diligence in assessing a strategy and/or track records results.
“10 Dimes Make a Dollar”
Hopefully, this demonstrates the importance of assessing risk/reward in addition to winning percentage when trying to determine the actual success, or profitability, of a trading strategy/track record. Remember, trading success not just about winning and losing individual trades—it’s about sustaining profitability over time (making money and holding onto those profits in the long run). The most common mistake newer traders make is in determining the success of a trading strategy (i.e. track record) based on winning percentage alone, which can be quite misleading when risk/reward is not taken into account. Most newer traders (unknowingly in most cases) are willing to risk far more than they are looking to gain (reward) just to be “right,” or win, each trade.
Another good piece of advice is to always keep in mind that trading is all about making profits over time , not about trading ego (which is usually the result of focusing just on winning percentages). In other words, significant returns can be achieved when you allow yourself to look at the big picture. As the saying goes, “10 dimes make a dollar.” The key is to be able to determine both entries and exits in advance so that risk vs. reward can be determined. This will significantly help to keep the decision making process as consistent and mechanical as possible, which is essential regardless of the technical/fundamental strategy that is used as it helps to eliminate emotions when making trading decisions. Only then can a truly objective decision be made as to whether or not to take the trade since this decision will be based on established/actual results, and not a “gut” feeling or reaction. Understanding the mathematical “law of averages” and “law of large numbers” reinforce this mechanical approach to trading which, again, is crucial to trading success because mixing emotions with money-based decisions is usually a recipe for disaster!
Review:Probailities In Trading
I often hear beginning traders speak as if they know what the markets will do next. In reality, experienced traders usually speak in probabilities and typically have some form of analysis to back up their opinion. No one can say that a particular currency pair (or other financial instrument) will move to an exact point with absolute certainty. In fact, I feel it is naive to think that anyone can predict the direction of a currency pair with absolute certainty over a given period of time. Sure, sometimes you could be correct if you boldly predict that a pair will move to X level with absolute certainty. However, there will be other times when the market doesn't go your way. That is why we must deal with probabilities, because no one knows for sure what will happen next in a given currency pair.
The reason we can never know where a currency pair with absolutely certainty is that the markets move based on the will of every market participant. Let's suppose that someone stated "the EUR/USD will definitely rise to point X, before falling down to point Y". They are saying that know exactly what every market participant (or trader) is thinking, how each of these participants plans to act, and how each participant will respond to the actions of every other participant. Needless to say, no one could ever have that information.
However, it isn't uncommon to see bold predictions that definitively state which direction a currency will pair and exactly where the move will begin and end. No one can know these types of moves for certain. Even worse, it isn't hard to find predictions that say something like "buy the USD/JPY at X or you'll be sorry." This baseless claim gives virtually no useful information because we don't have any idea how long of a trade this would be or where the exits (stop and limit(s)) are. Without being too harsh, just beware of anyone who claims they know for certain where a currency pair is headed. Of course everyone can be entitled to their opinion, but that doesn't mean they "know" what will happen next.
Even if an insider were to know about an interest rate change ahead of its release, that doesn't mean they can predict exactly how the market can act. What if the interest rate briefly rises the pair into massive stop-sell orders that actually moves the market down for the day? What if enough market participants felt the rate would move higher, so the pair moves lower? There are endless scenarios, but it is virtually impossible to predict how every market participant will act within a constantly changing market.
Therefore, we must think in probabilities. No matter how sensational your analysis is, sometimes you will simply be on the wrong side of the market. Whether you are looking at fundamental news announcements, a combination of of technical tools, or a simple moving average, what traders are looking for are patterns that put the probabilities in their favor so they will profit in the long run. In other words, they are looking for how the market has reacted in the past to certain conditions, and speculating how likely the market will react in the future to similar conditions.
Regardless of the tools you use to analyze the market, you are still working with probabilities. If you find a system that is profitable over a long period of time, that system is likely putting the probabilities on your side. These systems come in a variety of shapes and sizes. Some traders (like the famous Turtles), lost far more trades than they won. However, when they won, they usually won big. Some traders try to win the vast majority of their trades while risking a lot, but gaining little. Of course there are all sorts of variations and methods besides those two examples.
We will use the profit target system I use on FX360.com for the purpose of providing an example with easy math. This system requires 40% of trades to reach the profit target in order to break even. The reason for this is because the risk:reward ratio is generally 1:1.5. Therefore, if I win only 50% of my trades, I would be extremely profitable over time. Even winning 45% of my trades would lead to great returns. Anything above 50% wins would be outstanding. Therefore, it is plain to see that it is not necessary to know where the market will go on each individual trade. Instead, it is important to have a system that puts the odds in your favor over a large sample size of trades.
Based on these simple statistics, it is pretty easy to see why it makes little sense to get very excited when a trade wins or very upset when a trade loses. As long as the probabilities continue to hold over a long period of time, the individual results for each trade are almost meaningless. I lose trades all the time and so does every other trader. The key is to manage those losses correctly so that the long term track record is profitable. The bottom line is that thinking of trading in terms of probabilities is a key step to becoming a successful trader.
