When traders start out, they naturally want to win on every trade. But in reality, no matter what system you use, you will still experience losing trades. Many traders fail to understand that the profitability of a trading system is the result of many trades, not just one or two. Trading is like a journey, there are lots of ups and downs. In fact, there are more downs than winning periods for most traders. Beginning traders don’t think about losses during winning periods. But after a losing streak, they freak out and screw themselves up. Logical thinking gets thrown out the window and fear and self-doubt starts to creep in. If you can’t accept that trading losses are inevitable, it would be tough to build confidence in any trading system.
Equity curves of any good trading strategy are periodically stopped out, creating drawdown periods. Your drawdowns are very important trading statistics since they represent your risks by comparing possible rewards to its risks. It is the most important ratio to investors since it represents the maximum risk in any given trade. Being able to look back at a winning trading system, the number of losers in a row will provide confidence when your trading system experiences a losing system in the future. Although drawdowns look very easy to deal with when looking at the equity curve, they are actually difficult to manage psychologically.
Drawdowns are usually measured as the percentage between the equity curve’s peak and trough. These are the retracements in the equity from the previous equity highs, or simply the losing periods. The maximum drawdown is calculated by finding the highest peak in the equity curve and subtracting the subsequent lowest trough before the next higher peak in the equity curve. For instance, when an equity balance of $10,000 declined to $8,000, the drawdown is $2,000 (20%).
Profit periods and drawdown periods happen on a recurring cycle because every trading system was built to capitalize on a certain market condition. If a strategy was designed to profit in trending periods, then the strategy will surely do best during upward trend periods. But during a choppy market condition, the system will experience losing trades and even drawdowns. When a drawdown happens, it doesn’t mean that there is something wrong with the trading system. It means that the system should be traded in sync with the market condition it was designed for. This is the nature of all automated trading systems. It is important to understand these recurring cycles and come up with rules to manage them. Understanding drawdown periods help you to understand that there is no 100% perfect trading strategies, or such thing as “holy grail”.
Success in forex trading is the result of trades over a long period of time. Each trade must be viewed as a business transaction with risk reward associated with it. For illustration, a restaurant has the risk of having few customers, thus, it has poor sales. If the restaurant’s total costs are more than the total revenue it generates, it will have a loss at the end of the month. Similarly, trade drawdowns are the costs of doing forex trading business and winning trades are revenues. Your aim is to keep the costs of your business as low as possible and revenue as high as possible. This can be done by effectively managing the risk to reward on every trade.
Keys to diminishing your risk and drawdowns
Understanding the seasonality of Forex markets
Equity drawdowns could be affected by the seasonality of major forex pairs. Similar to commodities, the forex market has also calendar patterns which influence trading activities. There are months that a particular currency is unprofitable, and there are months that traders can take advantage to improve their odds for profits. Keeping on top of seasonality helps traders focus on strategies where probabilities could be in their favor. However, it’s not a guarantee that patterns will always repeat as they can change overtime.
Seasonality, or the patters that occur at a given time during a calendar year, is eminent among commodities and stocks traders and investors. Unsurprisingly, cases of seasonality are found on major forex pairs including EUR/USD, USD/CHF, and USD/JPY. Seasonality of EUR/USD and USD/CHF obviously occurs during the month of January. EUR/USD tends to lose ground while USD/CHF gains. The correlation between the EUR/USD and USD/CHF makes these two currency pairs usually move in opposite directions. The primary reason of the seasonality of these two currency pairs is because many investors withdraw all their profits at the end of the year, as well as bankers and traders go for Christmas holiday vacations. At the beginning of the year, most investors will start with a blank slate. But regardless of the time of year, the correlation between the EUR/USD and USD/CHF made these two currency pairs usually move in opposite directions.
The seasonality in USD/JPY for the month of January is slightly less than the seasonality in the EUR/USD or USD/CHF because Japan has a different ﬁscal year-end than the United States. Japan’s ﬁscal year-end is in March, which means there may be less profit-taking by Japanese corporations during the month of January.
May is a negative month for the USD/CAD. Since Canada is one of the world’s largest oil producers, Canadian dollar tends to be very sensitive to price of oil. During the month of March and April, oil price tends to rise and boost the profitability of Canadian companies, leading to seasonal improvements in economic data.
July and August are the peak months of summer in the northern hemisphere. In the forex market, the summer usually brings less volatile market since many traders in the northern hemisphere focus on enjoying their vacations.
September also brings a strong seasonality to EUR/USD, USD/CHF and the GBP/USD currency pairs. September is generally a busy and active month in the financial markets because of many expected economic new releases and political events, as well as ends the typical summer vacation time in the Northern Hemisphere. Traders anticipate a greater activity that could lead to breakout moves in currencies. Note: Using tools like ForexFactory & DailyFX can help you monitor high impact news releases which push currency pair prices.
Being mindful in the presence of forex seasonality, there are many ways to apply the knowledge of seasonality to improve your trading while avoiding possible losing streaks/drawdowns. History of seasonality will not always repeat itself. Blindly buying or selling at the beginning of a month because of the seasonal patterns is not the best thing to do, but being aware of it can help traders to decide where the probabilities lie. It may support an idea or reason to take or avoid a trade in a given month. For instance, being aware that seasonality of USD/CAD is very strong during the month of May, the presence of seasonality may encourage you to only take smaller position sizes than usual.
Understanding the correlation of currency pairs
Some currencies tend to move in the same direction, while others move in the opposite direction. If you are trading multiple pairs simultaneously, it is very important to know these correlations between currency pairs to avoid overexposure and doubling your risks. Trading pairs that are highly correlated will magnify your risk. However, it may also help you to predict the future direction and movement of a currency pair through the signals that you see on the other correlated currency.
EURUSD and GBPUSD exhibit strong positive correlation. When EURUSD goes up, we can easily conclude that GBPUSD also goes up. If EURUSD shows a sell signal, GBPUSD should also show a sell signal with minor differences in the strength and shape of the signal.
A well-known example of currency pairs moving in exactly opposite direction is the EURUSD and USDCHF. When the EUR/USD rallies, USD/CHF will sold off. This relationship even holds true over longer periods as the correlation figures remain relatively stable.
Correlations between currency pairs can be strong or weak, and can last for weeks, months, and even years. Correlations changes over time because sentiment and global economic factors are very dynamic and can change any time. Correlations can change due to a variety of reasons, which include diverging monetary policies, sensitivity to commodity prices, as well as economic and political factors. Thus, staying up-to-date with currency correlations can help you make better decisions when diversifying your trades.
You can effectively manage your trading by learning about currency correlation. It is very important to keep in mind the correlation between various currency pairs and their shifting trends regardless of your trading strategy-whether you are looking to diversify your positions or searching alternative pairs to leverage your capital.
Disregard your trading expectations
Some traders ignore the fact that any given trading strategy has a random distribution of winning and losing trades. You should not expect any specific trade to be a winner or a loser. Even if you have a trading strategy with a realistic high winning rate, you still do not know which trade will result in a profit or loss. Most traders forget that profitability of a trading strategy is measured over a series of trades. If you follow your strategy with discipline or patience to stick with its rules and apply proper money management over a large enough series of trades, overtime, you’ll become profitable.
Even professional traders lose money. However, they understand that they never know when a losing trade will occur. Thus, they never risk more money that they aren’t comfortable in losing. They get their expectations in line with reality. They make sure to manage their risk properly on every trade and never get upset when they hit a losing trade. They don’t expect to win on every trade they take and they don’t expect to become a billionaire overnight. They are honest about what is possible at the current moment given the size of their trading account.
Whilst amateur traders risk more money and are behaving as if they knew they will surely win on a trade. Struggling traders tend to become over-confident after a few series of winning trades in a row, and become vengeful after a losing trade. They jump back again to the market trying to make more money or make back the money they just lost. However, if you are faithfully following your trading plan, whether you won or just lost, you won’t jump back into the market for an emotional reason. To be aware of how much you should risk on a trade, always weigh the potential risk reward of the trade before taking the position, rather than only thinking about the reward.
Release all your expectations about any given trade by learning that losing money and being wrong about the market direction are both part of trading. It doesn’t matter if you win or lose. What matters the most is if you are able to maintain discipline, patience, and risk management. Forex trading is a business and the cost of doing this business are a no different from other businesses. You have to accept your loses and learn from them, rather than taking your loses personally and letting them make you emotional.
Capital preservation is the key to success with Forex trading
“First, I would say that risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice”. –Bruce Kovner
In the above quote from the Market Wizards, Kovner emphasizes about trading less, not over-trading, simplifying trading strategy and managing the risk of each trade. He believed in the philosophy “don’t trade unless there’s an obvious reason”.
Professional traders are more focused in defending their capital and managing risk than on how much money they can make. They have learned how to take and minimize losses. They predefined how much capital they are willing to lose if the trade goes against them. They measure risk in term of dollars, not in pips. Capital preservation is essential for long-term success.
Furthermore, “Emotional discipline” is a very important aspect that must be mastered by any trader. Dwelling on a lost trade causes negative emotions and will tempt a trader to make back the money they have just lost. Many traders fail to see that they are trading based on their emotions, not on logic. They trade on what feels good and safe. As a result, they cannot keep their winnings or control their loses, which often leads to losing streaks and equity drawdowns.
I would encourage you to take a long, hard look at the way you ‘play’ with your money. Your trading capital is the lifeblood of your Forex business for without it you will not be able to trade and will not be able to earn any money or returns. Remember to protect your capital at all costs and do not trade more aggressively than you ought.
Now tell me honestly, do you need to make some adjustments to your overall trading plan? Do you need to write out some cold, hard rules to follow in order to keep yourself disciplined and on-track with your risk strategy?
I encourage you to put everything in writing and brainstorm some ways to keep yourself disciplined day-by-day. Good luck!