Follow the Line of the Least Resistance

08/24/2010 12:01 am EST

Focus: FOREX

"A trend in motion will tend to continue in motion until a major event takes place that would cause it to change its direction. Trends do have greater odds of continuation rather than reversal."
- Mike Baghdady (35-year veteran of the financial markets)

The title of this article was first popularized by the market legend Jesse Livermore. Many successful traders are trend followers-following the line of the least resistance. Countertrend strategies can be quite profitable at times. But if one is wrong, the market can be unforgiving. It's better to follow the trend (the only challenge is that new trends don't always announce their arrivals). Though some may catch the trends early, depending on the trading methods they use.

I strive to make my points clear and simple. I invariably tell my trainees to analyze the markets and enter your orders. If you're wrong, cut your losses when it's clear the markets are no longer moving in your direction. If you are right, allow your profits to run. The principles that work are non-market-specific. The reality is that the easy thing to do is not always right and the right thing to do is not always easy. There are judgmental errors we tend to make. We know the golden rule, which makes perfect logical and rational sense. Studies have shown, however, that most humans will be more risk-averse in a situation of gain and less risk-averse in a situation of loss. Dr. Van K. Tharp calls this wrong psychological bias being "conservative with profits and risky with losses."

Simply put, many traders cut their profits and run their losses. The psychological reasons why they do this are beyond the scope of this small article. You might want to run your losses with the hope that the market could later turn in your favor. You might be right, but if you're wrong, the losses would be far bigger. You might cut your losses with the fear that the market would soon go against you. You might be right, but if you're wrong, you would have missed far bigger profits. Going against the golden rule was my major habit when I was a novice trader. You may be in the markets for 20 years without learning your lessons; changing from one trading system to another, receiving one margin call after another, while you know these calls aren't from pretty girls!

Sometimes the market may not even go in your direction by five pips before reversing against you. If I cut a loss at 80 pips, the market may later turn in my favor or move further against me by 500 pips. If I let a profit run, a winning trade may go against me later, or move in my favor by 700 pips. If I do the right thing and lose, I'll be happy. If I do the wrong thing and lose, then that's self-sabotage. Imagine what you'd have failed to gain if you'd cut your profits at 20 pips each on GBP/JPY and GBP/USD last week, and what you would have lost if you had let your losses run in the same week (please check your charts).

Whenever you set your stop loss and take profit, you just need a good risk/reward ratio for it to make sense. For example, does it make sense to use a stop loss -400 and a take profit +15 for every trade? Let me conclude with more quotes from Mike Baghdady:

1. ".It takes a great deal of time for a trend to change."

2. "A loss in momentum is not a sign of trend reversal, it is merely a pause."

3. "Prices never-ever-move in a straight line. Just by accepting this simple truth of how the prices behave, you will stop trying to pick tops and bottoms and view the corrections instead as an opportunity to take a trade in the direction of the trend."

By Mustapha Azeez of
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