Don’t get stuck in a sinking ship: Bail out in good time

ON AVERAGE, traders are right more than half the time that they trade, but despite that, many see themselves wiped out with big losses. But why is this? All things being equal, if you win more than you lose, you should come out ahead. But while traders are quite willing to cash in their chips when a trade goes to plan, they have a tendency to stay in a bad trade longer than they should, throwing good money after bad in the hope that their fortunes will turn around and the trade will come good.

The chart below shows data from FXCM, based on a data set of over 12m trades conducted between 2009 and 2010. It shows the 15 most popular currency pairs that clients trade. For example, in euro-dollar, the most common currency pair, traders were profitable on 59 per cent of their trades and lost on 41 per cent of their trades. Though this data is from FX trades, you would see a similar chart if you lined up the 15 most traded UK equities, or 10 most traded commodities. At the root of it all, all traders want to be right. It is one of the biggest draws of trading FX or spread betting. For £1 a point, you can take a position in the markets and, all going well, see your views and opinions vindicated as well as booking a profit to boot. But when things go wrong, it is difficult to admit. You want to stay in the trade, tell yourself that it is just temporary and that the markets will move in your direction eventually.

According to David Rodriguez, quantitative strategist for Daily FX, the easy to prescribe, but sometimes difficult to adhere to rule is: cut your losses early, let your profits run. “Avoiding the loss-making problem is pretty simple. When trading, always seek a bigger reward than the loss you are risking. This is a valuable piece of advice that can be found in every trading book,” says Rodriguez. This is referred to as a risk-reward ratio. If you risk losing the same number of pips that you hope to gain, then your risk/reward ratio is 1:1. If you target a profit of 80 pips with a risk of 40 pips, then you have a 1:2 risk/reward ratio. You should always use a ratio of greater than 1:1. By doing so, even if you are only right half the time, you will make a profit.

Once you have your risk/reward ratio strategy in place, the next step is to stick to the plan. The way to do this is to cue up your trade with stop loss and limit orders. Once they are set up, do not touch them – with the exception of moving the stop in your favour to lock in a profit. To illustrate the benefits of an adheredto strategy, the second chart from FXCM below shows the advantages of adhering to this system. The “raw” system follows a fixed strategy, but without any stops and limits. The trades made using the raw system are profitable 65 per cent of the time during the measured period, but lost an average of $200 a time on losing trades, while making an average of only $121 on winning trades. The red line shows the same line set with stops set at 115 pips and the limit at 120 pips, keeping the risk/reward ratio on the right side of 1:1. The second strategy did not have quite the same impressive rate of profitable trades, but still achieved a rate of 59 per cent. But crucially, its positive trades made more money than its negative trades lost, resulting in profits. Applying this strategy to your trades should prevent that sinking feeling next time the tide of the markets goes against you.