Forex Trading Mistakes to Avoid at All Costs

01/17/2014 7:00 am EST

Focus: FOREX

In the high-leverage world of retail forex daytrading, there are certain practices that, if used regularly, are likely to make a trader lose all they have, says Cory Mitchell of Investopedia.com and VantagePointTrading.com.

There are five common mistakes that daytraders often make in an attempt to ramp up returns, but that instead end up resulting in lower returns. These five potentially devastating mistakes can be avoided with knowledge, discipline, and an alternative approach.

1. Averaging Down
Traders often stumble across averaging down. It is not something they intended to do when they began trading, but most traders have ended up doing it. There are several problems with averaging down.

The main problem is that a losing position is being held, not only potentially sacrificing money, but also time. This time and money could be placed in something else that proves to be a better position.

Also, for capital that is lost, a larger return is needed on the remaining capital to get it back. If a trader loses 50% of their capital, it will take a 100% return to bring them back to the original capital level. Losing large chunks of money on single trades or on single days of trading can cripple capital growth for long periods of time.

While it may work a few times, averaging down will inevitably lead to a large loss or margin call, as a trend can sustain itself longer than a trader can stay liquid-especially if more capital is being added as the position moves further out of the money.

Daytraders are especially sensitive to these issues. The short time frame for trades means opportunities must be capitalized upon when they occur, and bad trades must be exited quickly.

2. Pre-Positioning for News and Data Releases
Traders know the news events that will move the market, yet the direction is not known in advance. A trader may even be fairly confident about what a news announcement may be—for instance, that the Federal Reserve will or will not raise interest rates-but even so, we cannot predict how the market will react to this expected news.

Often there are additional statements, figures, or forward-looking indications provided by news announcements that can make movements extremely illogical.

There is also the simple fact that as volatility surges and all sorts of orders hit the market, stops are triggered on both sides of the market. This often results in whipsaw action before a trend emerges (if one emerges in the near term at all). 

For all these reasons, taking a position before a news announcement can seriously jeopardize a trader's chances of success. There is no easy money here; those who believe there is may face larger-than-usual losses.

NEXT: Trading Immediately Following the News

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3. Trading Immediately Following the News
A news headline hits the markets and the market then starts to move aggressively. It seems like easy money to hop on board and grab some pips. If this is done in a non-regimented and untested way,  and without a solid trading plan behind it, however, it can be just as devastating as placing a gamble before the news comes out.

News announcements often cause whipsaw action because of a lack of liquidity and hairpin turns in the market assessment of the report. Even a trade that is in the money can turn quickly, bringing large losses as large swings occur back and forth.

Stops during these times are dependent on liquidity that may not be there, which means losses could potentially be much greater than calculated.

Daytraders should wait for volatility to subside and for a definitive trend to develop after news announcements. By doing so, there is likely to be fewer liquidity concerns, risk can be managed more effectively, and a more stable price direction is likely.

4. Risking More than 1% of Capital
Excessive risk does not equal excessive returns. Almost all traders who risk large amounts of capital on single trades will eventually lose in the long run. A common rule is that a trader should risk (in terms of the difference between entry and stop price) no more than 1% of capital on any single trade. Professional traders will often risk far less than 1% of capital. 

Daytrading also deserves some extra attention in this area. A daily risk maximum should also be implemented. This daily risk maximum can be 1% (or less) of capital, or equivalent to the average daily profit over a 30-day period.

For example, a trader with a $50,000 account (leverage not included) could lose a maximum of $500 per day. Alternatively, this number could be altered so it is more in line with the average daily gain. If a trader makes $100 on positive days, they must keep losing days close to $100 or less as well.

The purpose of this method is to make sure no single trade or single day of trading hurts the traders account significantly. By adopting a risk maximum that is equivalent to the average daily gain over a 30-day period, the trader knows that they will not lose more in a single trade/day than can be made back on another.

NEXT: Trading with Unrealistic Expectations

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5. Trading with Unrealistic Expectations
Unrealistic expectations come from many sources, but often result in all of the above problems. Our own trading expectations are often imposed on the market, leaving us expecting it to act according our desires and trade direction.

The market doesn't care what you want. Traders must accept that the market can be illogical. It can be choppy, volatile, and trending in short, medium, and long-term cycles. Isolating each move and profiting from it is not possible, and believing that it is will result in frustration and errors in judgment.

The best way to avoid unrealistic expectations is to formulate a trading plan and then trade it. If it yields steady results, then don't change it. With forex leverage, even a small gain can become large. Accept this as what the market gives you. As capital grows over time, the position size can be increased to bring in higher dollar returns.

Also, new strategies can be implemented and tested with minimal capital at first. Then, if positive results are seen, more capital can be put into the strategy.

Intraday, a trader must also accept what the market provides at different parts of the day. Near the open, the markets are more volatile. Specific strategies can be used during the market open that may not work later in the day.

As the day progresses, it may become quieter and a different strategy can be used. Towards the close, there may be a pick-up in action and yet another strategy can be used. Accept what is given at each point in the day and don't expect more from a system than what it is providing.

Bottom Line
Traders get trapped in five common forex daytrading mistakes. These must be avoided at all costs by developing an alternative approach. For averaging down, traders must not add to positions, but rather exit losers quickly with a pre-planned exit strategy.

Traders should sit back and watch news announcements until the volatility has subsided. Risk must be kept in check, with no single trade or day losing more than what can be easily made back on another.

Expectations must be managed, and what the market gives must be accepted. By understanding the pitfalls and how to avoid to them, traders are more likely to find success in trading.

By Cory Mitchell of Investopedia.com and VantagePointTrading.com

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