4 Reasons Why Forex Trading Systems Fail - Part 1

06/12/2014 9:00 am EST

Focus: FOREX

Forex traders are always in search of an edge, that winning trading system, but coming up with a consistently profitable one is not easy, notes the staff at FXTM, and what looks good in theory doesn’t always work well in a live market environment.

Whatever anyone may say, coming up with an effective forex trading system is no easy task. There are lots of things that need to be taken into account when designing a forex system in order to make sure it is robust.

Skipping any of these processes means that a trading system will ultimately fail when it comes down to it. The trading system could look good on paper, and that is often what draws people in, but profitable, robust trading systems are extremely hard to come by.

Curve Fit/Over Optimized
The number one reason why a trading system that looks good on paper might fail is that it has been over optimized or curve fit to recent market conditions. In other words, the system was never a good system in the first place; it was just made to look good on past data.

This happens when a developer designs a system but only looks at one set of data. She takes an in-sample period of data and then optimizes a system to work perfectly over that period. It’s worth noting that anyone can find a system that returns 100%—it’s as simple as testing hundreds of different combinations and settings.

The upshot is that trading systems that are only tested on in-sample data will never work when they are tested on real markets.

Poor Money Management
A very quick route to the poor house is to design a system with an unsustainable money management system that has no positive expectancy over long-term durations.

Unsustainable money management systems such as the Martingale system rely on continuously doubling up risk in order to win back money that has been lost.

A good example is found on the roulette table. The Martingale approach is to bet $1 on black and if it loses, double up and bet $2 on black. If it loses again, bet $4 on black and so on. Once the losing streak ends, the gambler is guaranteed to win back all of his losses plus a small amount.

The problem with this strategy is that no gambler (or trader) has unlimited funds. There will come a point where the losing streak is long enough that the gambler will run out of cash and he will be wiped out. The system is even less likely to succeed due to the commissions associated with betting/ trading and the maximum bet sizes that are imposed by casinos/ brokers.

Money management systems in forex never end well, in fact they always end up in a complete wipeout after a long-enough period. They do look good on paper though, as the Martingale technique proves, forex systems with this type of money management will produce a very consistent and smooth equity curve for a short while. Eventually though, the system will run out of luck.

By the Staff at FXTM

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