Note to Self

I just came across this angry note I wrote to myself last year after a particularly bad run of trades that could very easily have been avoided. Ever had that feeling? I find it often helps to scribble something like this down immediately afterward to help get that awful sinking feeling out of your system, and to remind yourself of the lessons you've (hopefully) learned. Enjoy...

You have completed screwed up [not the phrase I actually used] your trading discipline. You have lost over 200 pips because you:


• Exited trades too early
  
• Set arbitrary and unnecessary stop losses
  
• Allowed discretionary trading
  
• Failed to trade at the right time

You are no longer allowed to look at any trading application or chart outside of times you should be trading. You must exit all charts and applications immediately after placing a trade and keep them closed until it's time to review your position again.

On the bright side, the lessons I learned from this nasty period led me to trade with much more discipline in the months that followed, and as a result I've been having a good run so far this year.

Back in the Market After Some Forward Testing, a Bad Carry Trade, and a Bit of Boredom

Hello again, and apologies for this blog's recent suspended animation. For various reasons hinted at above I decided to give forex a rest for a while - but I'm now back and have just made my first foray into live trading the EUR/USD again.

The principal reasons I took a break were:

I was frankly a little bored and disappointed with the progress of my EUR/USD trading system. Out of impatience with its performance, I'd convinced myself it didn't actually work with real trades, it just looked good in backtesting. In fact, I ended up questioning the entire idea of backtesting since it offers absolutely no guarantee your trading rules will work into the future. So I decided to give it a break, and maybe come back in a few months, plug in the new data, and see if my system would've actually made decent trades in that time.

Around the same time, largely because I was disillusioned with my own trading system, I convinced myself carry trading was by far the best way to trade. So I devised what I thought was a very clever hedging system using the USD/CAD to balance the volatility of the carry trader's beloved GBP/JPY pair. But unfortunately I decided this just before the GBP/JPY carry trade experienced a giant melt-down that demonstrated how little I know about carry trading or hedging. So I got burned. Thanks to my stop-losses I didn't get wiped out, but I did get scorched pretty badly. (Did I mention I also broke my own trading rules by taking on way too much risk? Well, I did. And it was dumb.) In case you're wondering what a carry trade meltdown looks like, here's a picture. Congratulations to all the GPB/JPY shorts out there, it must've been a fun couple of months:


But there is some good news after this tale of burnout and reckless trading. As I mentioned, I've been letting my trading system sit idle for the past few months while new EUR/USD price data piled up. This new data was the raw material I needed to effectively forward test my system and see if it actually produced real, profitable trades, not just pretty pictures of historical backtests. When I plugged in the new data earlier this week, I was very pleasantly surprised: my system had racked up a very steady, consistent, profitable trading record while I was ignoring it. Which is why I'm back trading (and posting) again.

One of the trading risks I've described before is the desire to fiddle compulsively with your system, even when it's doing just fine as it is - the "If it ain't broke, don't fix it" problem. Since I'm a bit of a compulsive fiddler, my challenge now is to find something else I can fiddle with to keep me from breaking what isn't broke. One thing I've been wanting to learn for a long time is how to program Metatrader to trade my system automatically using their MQL programming language. I suspect it'll be quite a challenge transitioning all my trading rules from Excel to Metatrader - but if I can get them automated it'll save a huge amount of time over the long term. So if there are any experienced Metatrader programmers out there, any advice on getting started with MQL would be much appreciated!

Beware of Sloppiness

Yesterday I made a trade I shouldn't have, and I made it because I was rushing through my trading routine and not paying enough attention to important little details. In short, I was sloppy. And the result was I lost 21 pips I should never have even risked in the first place. That's the great thing about forex - you can usually put an exact cost on your mistakes.

In retrospect it's pretty clear to me why I was being so sloppy. I really wanted to make a trade, partly to make up for all my lost trades last week. I started updating all my price data with too little time to spare before my 5:00 pm trading window, so I was in a rush as well. Rushed data analysis + irrational need to trade = trouble. So when my system generated what looked like a valid signal, I placed a trade instantly without double-checking the key variables that went into the signal. It's always a good idea to double-check your data - especially if you're in a hurry.

The error I overlooked in my rush to trade was that I'd entered the date wrong. This isn't the first time I've gotten into trouble with dates, but in the past I took the time to double-check them. Not this time around. It's just about the simplest mistake I could make...and surprise, surprise, it's the simple mistakes that always seem to cost me the most. The good thing is they're also the easiest mistakes to catch.

So I guess the lesson here is, look before you leap.

The good news: a seven trade winning streak. The bad news: the last two don't count.

As if to prove that nothing can ever go completely right in forex, I woke up today to find that my trading system made its seventh winning trade in a row - definitely a new record for real trade predictions, not just theoretical ones in my historical backtests. The problem was, I couldn't make this trade, just as I couldn't make the sixth winning trade last Friday (as I mentioned in my previous rant). The reason being my trading platform FX Engines was still down, and still is last I checked. While I've had a lot of good things to say about FX Engines in the past, this is approaching an unacceptable level of downtime during live trading hours. I can certainly sympathize when a server goes down, which they inevitably do - in fact, I've worked at a dotcom start-up where screwy servers gave me a couple extra weeks paid vacation. But can you imagine what would happen if a big player like Charles Schwab or E-Trade (or Oanda, or GFT, or you name it) went down for two trading days, three if you count the Asian trading session on Sunday? Even if you're a small player, you're going to need the uptime and reliability of a big player if you want to compete.

Anyway, I just had to vent a little because it's kind of a bummer to see a nice run of trades killed off because of technical difficulties, which of course never seem to crop up during a losing streak. That's the last I'll say about it, I promise. Well, unless it happens again.

Happy glitch-free trading!

Missed a winning trade. But I'm not upset. Really. OK, maybe a little.

If you've been following the blog much lately you'll know that I currently get a lot fewer trading signals because of some strict filters I've set up. So when a trading signal does come along, it's a big deal. And yesterday I got one to go short the EUR/USD for 22 pips, and in the ranging price action that followed it turns out it would have been a winning trade. Which would make it the 6th winning trade in a row, possibly setting a new record if I kept track of these things. But I couldn't make it, for a couple of reasons.

First, I was out hiking with some friends and then out having a beer at a favorite venue in San Francisco. So I missed the ideal entry point for my trade, which was at 5:00 pm, just as I was wandering around the forests south of here. When I got back, 10 pips profit had already been shaved off the trade, so it would've been only a 12 pip trade.

All of which is entirely my fault and if the trade had been enough of a priority I clearly would've been sitting right here glued to my laptop. And I wasn't, and while I'm a little annoyed with myself I still had a fun afternoon. And fun has a cost, which in this case can be measured in pips.

The second reason is that FX Engines, my trading platform, had a server go down and wasn't working at all. This is the first time they've gone down during trading hours and it came as a bit of a nasty surprise. Who knows, maybe if I'd showed up on time the site still would've been up and I could've made the trade, but there's not much point in wondering about it now.

Anyway, the upshot of all this was: no 22 pips, and a break in a nice winning streak. The larger lesson, and one I think I'll revisit in a more comprehensive post on the subject, is that there are a lot of unforeseen logistical risks to your trading lurking out there and you'd better be ready to fix the ones you can (like being on time for a trade, if that's important to you) and accept the ones you can't (like your broker's server going down). And if the same problems keep cropping up, it might be time to make some changes to your trading setup. But more about all that in a future post...

Risk/Reward Ain't Always What It Seems

It's very easy to get caught in the illusion that a tight stop-loss and a generous take-profit/limit order are going to earn you profits in that ratio. You know, setting your stop at 20 pips, your take-profit at 50 pips, and waiting for those consistent profits to start rolling in. This is a newbie error I made plenty of times before learning my lesson. What I've found since then is that a very generous stop-loss and a conservative take-profit strategy is often more consistently profitable.

A case in point: I'm currently running a GBP/USD trading system that features timed exits of around a week, take-profit at 100 pips, and stop-losses set at 300 pips. Yes, 300 pips. Sounds a bit weird, I know, but the key here is that those stop-losses almost never get hit. What's far more likely is that the price will advance 100 pips in that week, or the trade will time out if it doesn't (and sometimes with a profit). In fact, I could probably run the system without a stop-loss at all and the results would be similar, thanks to those timed exits - I'll have to backtest that notion soon, though the idea of trading without any stop-losses makes me nervous.

In general I've found that stop-losses work best for me in extreme emergencies, when the market is acting wilder than usual and hence could lose me more than usual. So for my trading style it makes sense to set them at the outer limits of the likely trading range, rather than squarely in the middle of the range where they're likely to get hit by a whipsaw or retracement.

Whipsaws and Fake-outs

Some of the most frustrating and costly market phenomena a trader is likely to see are whipsaws and fake-outs. Actually these are pretty much the same thing, with the difference that calling it a fake-out attributes a negative intention to the market, essentially accusing it of messing with your head. And a whipsaw or fake-out can indeed have a serious impact on your confidence in yourself and your trading system. If you spend your days looking for price break-outs and trends and instead you get a string of these nasty up-and-down spikes, you may wonder why you got into trading in the first place. The past couple weeks have been a vivid case-study in whipsaws and fake-outs, which is why they seemed like a good topic for today.

So what is a whipsaw/fake-out, exactly? It's a point in the market where the price moves dramatically up or down, and in the early stages may look identical to the start of a new trend. Then, instead of continuing the trend or leveling off, it'll suddenly dive back down (or up, in the case of a downward spike) to a price close to where it started. If you've watched forex charts for any length of time, they've almost certainly crossed your path. But if you're new to the currency markets, or aren't sure exactly how to spot one, here are a couple from the past week's EUR/USD market.


What causes them? Well, almost by definition they are points when there is insufficient momentum in a particular direction to sustain a trend. Because market sentiment is ambivalent, divided fairly evenly between longs and shorts, the price is able to continue its break-out and falls back to where it started. If you've placed your limit/take-profit orders at an optimistic price point in anticipation of a strong trend, you're likely to find the whipsaw comes nowhere near them and lands you back within a few pips of your entry price, and a few pips poorer thanks to spread costs.

The most dangerous whipsaws include price spikes in both directions, which after convincing you to place a trade in the direction of the first spike, then turn around and take out your stop-losses with the second spike.

If we broaden the definition a little bit, stop-hunting could be considered a type of whipsaw that's staged by a broker within their own trading platform with the specific goal of hitting their clients' stop-loss orders. If you see a whipsaw on your broker's charts but not on anyone else's, chances are you got stop-hunted.

That's not to say you can't make money on a garden-variety whipsaw or fake-out; I have no idea if it's possible during stop-hunting. If you're good at identifying markets in which they're likely to emerge (like the current one), you can adjust your trading strategy accordingly by placing your limit orders at levels closer to the entry price than you would in a trending market. You might also try combining these more modest limit orders with a tight trailing stop to help prevent all your profits evaporating when the price suddenly changes direction.

Or, if you're like me and find whipsaws and fake-outs too nervewracking, unpredictable, and costly to play with, you can work on filtering them out of your trading by avoiding market conditions when they occur. In my experience these tend to be in range-bound markets with low volatility and little notable economic news to fuel a true break-out. I'm sure someone out there is getting rich off these things, but it's definitely not me!

The Trillion Dollar Bet - Lessons from Long Term Capital Management

A while back the PBS series "Nova" did an excellent show called "The Trillion Dollar Bet" on the rise and fall of Long-Term Capital Management (LTCM), a hedge fund founded by Nobel Laureates Myron Scholes and Robert Merton. LTCM placed massive leveraged trades in derivatives (hence the show's title) and then collapsed in truly spectacular fashion in 1998 following economic turmoil in Asia and Russia, and for a brief period threatened to take much of Wall Street with it. You can read the entire transcript online, and it's well worth a look - a fascinating window into how things can go wrong for even the most rigorously calculated and tested financial models.

At the heart of LTCM's implosion, like that of Amaranth Capital, were common problems that every trader should be aware of: the potential for unexpected drawdowns in turbulent market conditions; the fallibility of trading rules and signals that depend on past market behavior and unquestioned assumptions about future behavior; and taking on too much risk through extreme leveraging.

A number of scholars, experienced traders and fund managers appear in the show, and their observations are some of the most valuable insights I took away from it. Here are a few highlights:

Leo Melamed: "You can't ignore an error. Once you realize that you've made an error, the best thing is to get out of that error and start again fresh, and that's what a good trader does."

"That's an old market rule: the market will test you and do what you don't expect it to do."

Stan Jonas: "It was as though the world was behaving exactly the way it had been writ on the blackboard...And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent."

"When do you admit that you're wrong, start all over again, or when do you hang on and assume that the markets will turn around in your way? That's the biggest decision we all have to make."

Roger Lowenstein: "Although their models told them that they shouldn't expect to lose more than 50 million or so on any given day, they began to lose 100 million and more, day after day after day till finally there was one day, four days after Russia defaulted, when they dropped half a billion dollars, 500 million in a single day."

Alan Greenspan: "How much dependence should be placed on financial modeling which for all its sophistication can get too far ahead of human judgment?"

Peter Fisher: "If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on."

Related links:
Nova Transcript
Trillion Dollar Bet Website

Related topics:
A Cautionary Tale from an Incautious Hedge Fund
Taking On Excessive Risk

Taking on Excessive Risk

This seemed like a good topic for today because I've been taking on too much risk at certain points in my trading without really thinking about it - and I suspect that's how it happens to a lot of traders. My risk management mistake is failing to scale back my position after a loss if I decide to continue the trade in the same direction. This happened today as I decided to continue a long trade I started yesterday. Both trades went the wrong direction thanks to some good US CPI numbers, and according to a strict fixed fractional strategy I should have jettisoned a few mini-lots today to bring my position into the proper ratio with my reduced capital. But I didn't, ending up with a position, and a loss, that is significantly larger than it should be.

There are a few reasons I give myself for failing to scale back losing positions like this: (1) overconfidence that my system's accuracy will turn the loss around quickly and fix the problem (2) the fact that I hate spending money on spread costs, and I'd have to spend more to exit and then re-enter positions with a smaller lot size (3) concerns about sloppy execution and losing a few pips in the time it takes to exit and enter the trades. The last two reasons are somewhat valid, but the amounts I'd be saving are almost certainly smaller than what I'm losing by taking on too much risk.

In my experience, excessive risk tends to creep up on you like this when you're not paying attention, or paying attention to the wrong things, like that loss you really need to recoup in a hurry. Some common justifications for taking on too much risk that you might want to watch out for are:

• Just this once - kind of like that last drink or cigarette before you quit.
  
  
• Total impulse - you prevent yourself from thinking about it, you just leap without looking because forex is only interesting if it's a gamble.
  
  
• Good reasons for a bad idea - sure, saving on spread costs is a good idea, but not if you end up risking 25% more than you should.
  
  
• False sense of security - you set a very tight stop-loss and it keeps getting hit over and over again. In this case the thing that makes you feel safest in your trading is actually the biggest threat to your success.
  
  
• Boredom #1:I haven't analyzed my trading and I don't feel like it because it's boring, and therefore I have no idea what's too risky.
  
  
• Boredom #2: Trading with lower levels of risk is incredibly boring and way too much like my day job to be worthwhile.
  
  
• Starting with an unreasonable goal and reasoning backwards from it - I'm in a hurry to get rich and I can only make $1 million in 6 months if I take on this much risk.
  
  
• Pursuing a statistically valid but aggressive strategy like Martingale without the funds to back it up.
  
  
• Setting up an automated trading system but failing to monitor it closely and after a losing streak it ends up risking way too much.
  
  
• Misidentifying high risk events as low risk. For instance, trading on big news events can seem like a higher reward/lower risk scenario. All you do is see which way the trend is going and jump on it, right? But then there are the whipsaws, and the stop-hunting, and the various fake-outs the market likes to pull at these times, and what seemed low risk turns out to be quite risky after all.
  
  
• "Picking up nickels in front of a steamroller" - certain types of carry trading have been described this way. It's easy to focus on a reliable trickle of profits and be lulled into ignoring the underlying risks of your position. This is another example of misidentifying high risks as low risks.
  

Those are just a few of the ways this can turn into a very risky business very quickly. If you've got more to suggest, please post them in the comments...

How Often Do You Break Your Trading Rules?

In my opinion two of the quickest ways to end your trading career are (1) trade without a system and (2) break your trading system's rules constantly, which is basically the same thing. I've also found that one of the best ways to improve your trading consistency, and the performance of your trading system, is to develop feedback loops that identify flawed strategies and costly behavior patterns and filter them out of future trades.

One way to do this is by keeping a detailed log of every time you break your trading rules. Each time you break a rule, record what rule you broke, what reason you gave yourself for breaking it, and the outcome of the rule-breaking trade (or missed trade). Reasons you might give yourself for breaking a rule are:

• This was an extra-special one-of-a-kind case because X happened
  
• That's a bad rule anyway
  
• This trade doesn't really count
  
• I have a second unofficial trading system that exists in a parallel universe
  
• I was angry about the previous trade
  
• I was happy about the previous trade
  
• I was tired
  
• I was bored
  
• I was scared
  
• Etc. etc. etc.
  

Once you start identifying and recording the reasons you go astray, you're likely to become far more aware of the patterns that are causing you to break the rules - especially when you can see what the consequences are. You can't correct what you're not aware of, so with that awareness will hopefully come the motivation to improve your trading discipline.

You may even find that certain types of rule-breaking are consistently profitable (seems unlikely, but you never know) and may point the way to new trading strategies. But you won't know what they are unless you keep a detailed record.

Another potential benefit with implications beyond forex is that you'll come to know your own mental habits better. Trading can be an excellent case study in how you relate to the world, and by recording flaws in your trading, you may also start seeing other negative patterns in your life more clearly. For example, perhaps you're indecisive and procrastinate when you're scared, or impulsive and inconsistent when you're angry. Knowing these patterns can help you navigate around or through difficult patches more successfully in the future, both on and off the trading screen.

OK, I'm sure you get the idea...I'll save the rest for a self-help book ;-)

Related topic:
Sticking to Your Trading System

A Common Error, Revisited

I just ruined a couple hours of work by committing one of the common errors that always seem to crop up when doing analysis of market data. As I discussed in this post, it's easy to generate trading signals that look too good to be true by not correlating your dates properly. To quote myself, "I'd been using a signal derived from one day's market activity to predict that same day's activity, rather than activity the following day."

Well, I did it again. In an effort to branch out from forex trading into other markets, I've been doing research into how the behavior of certain stock market indices (or indexes, if you prefer) affects the movement of their component stocks. So I was looking at how the Philadelphia Semiconductor Index affects the activity of Advanced Micro Devices stock (ticker symbol: AMD). And I came up with the most amazing signal, an almost perfectly straight line shooting upwards and promising to make me filthy rich within a year or so. Or so it appeared. (I won't post a picture of the chart in question because it's just too painful to look at.)

After congratulating myself on finding such a perfect correlation, I began to look more closely at this signal that my wishful thinking had assured me was the real thing. Well, it turned out that early on in my table of historical prices, one day was out of place, and my signal had shifted from reflecting the previous day's prices, to the current day's price. So if the index went up 1% on a given day, surprise, usually AMD did too. The lesson being, if your signal looks too good to be true, there's a good chance it is...so take a closer look at the underlying data and check your work to make sure it's the real thing.

For the record, there are significant correlations between the semiconductor index and AMD stock - just not as significant as I'd first thought. Oh well. At least I caught the error early, before urging all my friends to sign over their bank accounts.

Related topic:
Common Errors When Designing a Trading Strategy

Beware of selection bias when designing your forex trading strategy. (Or, how wishful is your thinking?)

An important principle to keep in mind when putting together a forex strategy is the need to avoid bias (aka wishful thinking) from affecting your judgment about what constitutes a signal, a chart pattern, or a trend. In science this is often called the "file drawer problem", referring to the fact that researchers may consciously or unconsciously relegate data that conflicts with their experimental hypothesis to a file drawer, thereby skewing the results of their research toward the conclusion they'd like to be true.

Let's say you're evaluating a chart-based trading system and looking back through old charts to see what happened in the past when it signalled trades. Are you paying equal attention to the times it failed and yielded a loss? Are you adding up these losses consistently and factoring them into the system's overall trading results? Or are you finding subtle ways to discount these failures, and judging them on a different standard than the successes?

For example, do you tell yourself "I would've gotten out of that trade quickly anyway, since it would have been obvious it was going the wrong direction"? Or "This one doesn't really count as a signal because it only crossed over for a very short period." Or "I would've sold when it spiked up like that, before it crashed back down for a loss." And so on...there are an almost infinite number of ways you can shape the data to convince yourself it's a viable forex system. It's human nature - though certainly one of its more troublesome aspects.

You owe it to yourself and your trading account to maintain strict standards, with as little wiggle room as possible, when deciding whether a currency trading strategy is likely to work for you. Believe me, it's a lot better than finding out the hard way.

Related topics:
Common Errors When Designing a Trading Strategy
Don't Let Your Charts Deceive You

Signs You May Be Overtrading

As a recovering overtrader, I'm more than a little familiar with how easy it is to jump compulsively into a trade without regard for your strategy or for the consequences, which can often be costly. I recall one night I found myself up at 2:30 am while the EUR/USD market bounced up and down and I kept trying to bounce with it, except I was always too late, and I kept thinking the next trade was the one that would finally get me out of the hole. That was a very expensive night, and I don't remember sleeping much after finally heading to bed after 3:00. But even the worst nights have a morning, and so did this one: that one bad night of overtrading was the turning point that led me to begin developing a rigorous, tested, disciplined (usually), quantitative trading strategy.

Since I still periodically feel the urge to begin trading anytime I glance at a forex chart, I thought I'd share some warning signs that you might need to cut back your trading and think about a more strategic approach to the markets. Trust me, this is as much for my benefit as yours - I'm going to keep this list onscreen right beside my charting software.

1. If one chart indicator doesn't have a clear trading signal, you switch indicators until you find one that does (or looks like it does). What you're really doing in this situation is trying to find a signal that you can read enough into to justify placing a trade. The fact is, there are times when there just aren't any good trades to be had and you should be sitting on the sidelines. If you can't accept that, you'll end up making lots of trades you shouldn't.

2. You feel the urgent need to place a trade within five minutes of opening a forex chart. Just looking at the chart makes you feel you absolutely must be trading right now, and anytime you open a chart you spot some trend or indicator that you should be taking advantage of. You're a bit like the person who needs to place a bet anytime they walk by a roulette table.

3. When you're away from your forex trading platform, you feel like you're constantly missing trades. You feel intense frustration and disappointment when you see a trade you could've made but didn't. You spend a lot of time thinking about those trades you missed. Sometimes you wish you could stay awake 24 hours a day because then you wouldn't miss out on all those trades.

4. You have a trading system but you constantly make exceptions to it. You have an ever-growing list of excuses and rationalizations for why you trade outside your system:

• You'll only do it once (until next time)
• You're not risking very much
• The chart is showing the perfect trade set-up and you'll miss out on huge profits
• Look how active the market it right now! I have to trade since everyone else is.
• I'm trying out this new experimental strategy (well, then try it out on a demo system)
• This trade is actually part of my system, since I keep extending my system to include all my trades
• My system hasn't been working lately anyway
• It'll take my system at least a year to make me rich and I want to be rich next week

5. You're focused on "the one big trade" that will make up all your losses, and you're willing to make dozens of ill-advised trades just to make sure you don't miss that big one. And guess what, you discover no one trade is going to make up for all you've lost in bad trades and spread costs. At this point you might as well be buying lottery tickets.

6. You think that trading more often will make you more money. "If I can make this many trades with the 5-minute chart, imagine how many I can make with the 1-minute chart!"

My experience has been the opposite.

7. You think that anticipation, anxiety, impatience, urgency, late nights, a pounding pulse, and the rush of adrenaline are all part of trading and there's no way to trade without them. You're under the impression that you're more likely to trade well under these conditions.

8. You make trades so you can tell people about them. "Yeah, I traded the zloty at 3:00 am last night - pretty crazy, eh?" Yes, you're a brilliant, maverick currency trader, and you'll be broke in a month.

9. You have a "gut instinct" for trades that makes different, contradictory predictions every time it kicks in.

10. You can always find a way that your trade could have gone well, if you'd only done X, Y, and/or Z, and you resolve to do all of those next time. In fact, just to prove how well they'll work, you're going to trade again right now.

11. You cut short your weekend so you can trade on Sunday evening when the Asian markets are open. In fact, you find the whole weekend concept very inconvenient since you'd much rather be trading on Saturdays.

12. You have a history of being addicted to things and forex is the latest. This is no joke - there's a very real high to be gotten from trading, akin to the high from gambling or other addictive activities, and if you're especially sensitive or vulnerable to that type of response, you should be very careful about venturing into the currency markets. This is related to #7 above - many of the reactions I listed there are part of a potentially addictive physiological response, particularly for those with a predisposition in that direction.

I'm sure there are many more signs and symptoms of overtrading, so if you have any to add to this list, please submit them via the "Comments" link below.

Related topics:
Stop wasting pips! Strategies for cutting your trading costs
Limiting your emotional exposure to the markets
Trading at all hours? Get some sleep!
How I just wasted a bunch of pips for no good reason

Don't let your charts deceive you. Remember, scale is everything

One risk of chart-based trading strategies is misinterpreting, or overinterpreting, the visual data presented by a chart and concluding that a new trend is emerging when nothing could be further from the truth. We humans are visually-oriented creatures, and are inclined to see patterns even when they aren't there. The risk of jumping to false conclusions based on a chart increases when you're looking at a time scale much shorter than you're used to, displaying pip ranges much smaller than you're accustomed to.

For example, I recently switched from an hour chart to a five minute candlestick chart and was amazed at the exciting trends that were suddenly jumping out at me from the screen. I quickly realized that what looked like major movements were in fact just upticks of a few pips, and that the shorter time scale gave the illusion of faster, more dramatic market activity. When I switched back to my hour chart, it became clear that all the movement was actually happening within a very narrow range.

When I first got started trading, I would often be staring at a 5 minute CCI (Commodity Channel Index) chart for hours, even during the low-volume doldrums of the afternoon, since I didn't know any better. One of the problems I had with the CCI as a newbie trader was that what often looked like an important trend on the chart, as the CCI shot upward or plunged downward, was often just a movement of 7 or 8 pips. The CCI is like that: it can swing widely up and down regardless of whether the price is moving 10 pips or 100 pips. If you don't keep a careful eye on the price and just watch the CCI, you might end up making a trade that looks big on the chart and ends up so small it's hardly worth your while. I found this was especially true during those afternoons, when the CCI would continue to spike up and down based on the smallest price movements. I eventually found it helpful to have a candlestick chart running alongside my CCI chart to give me some more perspective on what the price was actually doing.

Remember, a chart signal or indicator will work with whatever prices are fed into it, keeping up a constant visual chatter even when there's not much to talk about. Many charts and signals will also shift their scale to fit whatever the current range is, which can create an illusion of market activity even when volumes are low. A CCI or Bollinger Band or ADX or MACD won't just turn itself off and say, Hey, charting these prices isn't worth my while, and it's likely it lose you money as well. They'll just chart what's there, and it's up to you to decide whether they're saying anything meaningful. Often they aren't, and there are many times when the best strategy is to just leave your charts for a while, go get lunch, watch the Simpsons, have a beer, go swimming, walk the dog, and come back to them when the market's really moving.

Related topics:
The Perils of Chart Burnout
Common Errors When Designing a Trading Strategy

Common Errors When Designing a Trading Strategy

When wrangling spreadsheets and charts with historical forex price data, it can be surprisingly easy to make the most basic types of errors that, if not caught quickly, can lead to all kinds of mistaken conclusions and costly trades. I've compiled a short list of the ones I've been guilty of at one time or another, which I hope will be helpful to you as you design your own trading methodology.

Error 1: Don't correlate your dates and times properly.

I once discovered a forex trading signal that seemed too good to be true, predicting market movements with truly amazing accuracy and racking up huge gains on a consistent basis. Well, it turned out it was too good to be true - I'd been using a signal derived from one day's market activity to predict that same day's activity, rather than activity the following day. By lining up my dates incorrectly, I ended up with a circular signal that essentially predicted itself. No wonder it was so phenomenally accurate!

That said, misaligning your dates can also lead to some interesting discoveries. For instance, I once did a study to discover how London Stock Exchange (LSE) activity correlated to GBP/USD trading the following day. Only I mistakenly used LSE data from two days previous, not one day. As it turned out, this led to some fairly significant predictions.

So, be open to the possibility of an auspicious accident, but make sure to double-check your dates and times to avoid the nasty accidents, which tend to be far more common.

Error 2: Use the wrong metric of success

This is another of those too-good-to-be-true stories - yet again, I found a signal that looked like it yielded amazing profits. Well, it turned out I was adding up the wrong numbers. Instead of totalling all trades generated by that signal, I'd added up a column of all the positive trades it had triggered. No wonder the totals looked so good. The metric I should have been using was one column over, and recorded all trades indicated by the signal. And it was, surprise surprise, quite a bit lower.

Another way of confusing your metrics is to focus on the percentage of positive trades rather than the total gains a signal generates. While a 70% success rate looks pretty good, it could be outperformed by a signal running at just 50%, or even lower. A signal that generates 100 pip profits half the time and 30 pip losses the other half is a lot better than one generating 30 pip profits 70% of the time and 50 pip losses the other 30%. (Sorry if I'm stating the obvious here...but it's not always obvious.)

Error 3: Use the wrong periodicity (time span) for your signals

If you're planning to place day-long trades, you'll probably have more luck using daily charts and price data than 5-minute charts. And if you're planning to do short-term scalping, daily data may not be as helpful as a minute-by-minute chart.

Error 4: Use Too Small a Set of Data

When testing out a potential signal, you'll need a substantial body of market data to determine how it performs over time. A strategy tested on 10 trades over three weeks is likely to be a lot less robust than one tested on 500 trades over three years. The more historical price data you can obtain to put your signals through their paces, the better.

Error 5: Forget to take the spread into account.

I've discussed this before, but it's always worth revisiting. You may have a system that makes you 10,000 pips trading the EUR/USD, but if it takes you 5000 trades to do so, you could very well end up making very little, or even losing money because of the spread. One factor to look at when evaluating spread costs is how many of your trades are sequential: if you tend to have blocks of 10 trades that you can roll into one trade, then you have less to worry about than someone with many sporadic trades occurring in isolation.

Obviously this is far from a complete list of all the errors you can blunder into when creating a forex system -- so stay tuned for more mistakes as I make them.

Related topics:
Don't let your charts deceive you
How I just wasted a bunch of pips for no good reason

How I just wasted a bunch of pips for no good reason

I thought I'd share a trading experience I had today that perfectly illustrates one of the bad habits I mentioned in my Stop Wasting Pips! post. Among other things, it proves just how easy it is to ignore your own advice and keep doing things that could shorten your trading career if you don't learn to keep them in check.

So here's what happened. It was around noon, and I was up over 600 pips for the week on various manual and automated trades on FX Engines. Now FX Engines places its trades through FXCM, which closes its trading day on Fridays at 4:00 pm EST, or 1:00 pm my time, in California. My plan was close out all my trades for the week, which I generally do on Friday, with plans to re-enter the market on Sunday evening. (Whether I even needed to do this is another story...so I'll save it for another post.)

Though it was an hour until the market closed, being me I just had to check in early. And I noticed that the EUR/USD price seemed to be drifting down a little bit...a few pips, then a few more. And so, inevitably, I started getting ideas. I thought maybe I should get out of the market a little early. You know, in case it lost another 10 pips, which would've been just terrible. So that's exactly what I did -- I bailed out of all my trades shortly after noon. And, to be fair, they were good trades, and I made quite a bit of money on them. However, when I came back and checked the price again just before 1:00, it had shot up 20 pips from where I'd exited. To be precise, the EUR/USD was at 1.2927, and I'd gotten out early at 1.2907. If I'd followed my system and gotten out just before the market closed, I'd have been 20 pips richer, which worked out to a lot more in dollars since I was trading multiple mini-lots.

Of course, there could be times when there is an advantage to getting out early. But since I have no evidence that it would be a consistent advantage, it doesn't qualify as a trading system or strategy. It qualifies as a bad habit, and one that erodes the disciplined, rule-based trading techniques that are essential to success in this market.

So, that's how easy it is to ignore your own trading rules, make a snap decision based on anxiety and a very short-term horizon, and end up wasting a pile of pips. I think it's time for me to go re-read my own advice. Maybe it'll sink in this time.

Stop wasting pips! Strategies for cutting your trading costs

One of the most important aspects of any forex trading strategy is containing your trading costs, which helps ensure that you're squeezing the most profit out of every trade and aren't drawing down your funds with pointless trades and careless execution. Here are some of the common ways for you to waste your money while trading, all of which I've been guilty of at one time or another; how do you think I discovered them?

Forgetting to take the spread into account: seems obvious enough, but it's easy to forget that every time you place a trade you're paying the spread right up front, and if your trades have a narrow margin of success, a big chunk of your earnings is going to be eaten up by the spread. And if you're not executing your trades perfectly, that chunk is going to be even bigger. Another surefire way to get screwed by the spread is to take a trading strategy from a pair with a low spread, like the EUR/USD, and try to use it for a more exotic pair with a much larger spread. You may quickly find yourself spread way too thin. (Excuse the pun.)

Overtrading: maybe you get a great new trading idea every hour or so. Maybe you change your mind about a trade that seemed perfect at the time but isn't going the way you'd planned. Maybe you feel like getting into 5 different currencies at the same time, for no good reason other than you like variety. All of these undisciplined trades are going to burn up pips like wildfire, and in the long run are unlikely to repay you for those added costs.

Testing an unproven strategy with real trades: whether you've invented it yourself, gotten it out of a book, or found it on a web site, any trading system that you start using in the live forex market without prior backtesting and/or a trial run on a demo system is likely to cost you plenty of pips as you learn its idiosyncrasies and weaknesses the hard way. I lost a lot of money this way - for my first foray into forex, I just grabbed a trading system off the shelf (well, the Internet) and assumed it would work because lots of people seemed to be using it and had testimonials about it all over the web site. I started trading with this system after only a few hours of practice on a demo platform, and quickly discovered that I had no idea how to make it work consistently...except when it came to losing me pips, which it was great at.

Trading exotic pairs with a big spread just because you like the idea. This goes back to point 2 about forgetting the spread. If you're drawn to exotic pairs because you like dropping references to the Thai Baht or Polish Zloty in conversation, then do yourself a favor and just trade them with a demo account. Most people you try to impress with your exotic trading prowess won't know the difference, or care.

On the other hand, if you happen to have worked for the Central Bank of either of these countries and know the currency's behavior by heart, by all means, go right ahead and put real money on the line.

Combine trades whenever possible: don't take profits on a trade if there's a high likelihood you'll just be re-entering the market again in the same direction soon. (Unless your plan is to get out in anticipation of a big dip and then buy at the bottom.) If you don't expect dramatic changes, stay in the trade - you'll cut your spread costs in half. Do it again the next time you're tempted to jump in and out of the market, and you'll cut them by two-thirds. You get the idea. (This is probably just another way of saying don't overtrade.)

Compare spreads on different trading platforms: you may be able to save a pip or more in spread costs with a forex broker offering lower spreads. Even if you're just saving one pip on each trade, it'll add up - and if you're fortunate enough to rack up significant trading gains and begin placing larger and larger trades, that one pip savings could eventually be 5 pips a trade, 10 pips, 50 pips, and more. To the best of my knowledge, the broker offering the lowest spreads at the moment is Oanda, which has a mere 1.5 pip spread on the EUR/USD pair. Oanda will also let you place tiny trades of as low as a dollar, which leads me to my next point...

If you must trade an untested system with actual money, since demo trading just doesn't feel "real" enough (and yes, I know what you mean, there's nothing like real money to focus your attention), then start out placing tiny trades of under $10 with a broker like Oanda. This will allow you to feel like you're making (or losing) real money while preserving your funds and your sanity by reducing the size of your losses. It's a bit like playing the nickel slots at a casino to make your cash last longer - though hopefully the odds will be a lot better.

Finally, at the risk of repeating myself, the best way to save pips is to thoroughly test your trading system and then execute trades with consistency and discipline. Remember, the data is your friend, so treat it like one - spend lots of time with it, get to know it better, check in on it every day, and it may just pay you back handsomely.

Related topics:
Simplify Your Trading
Signs You May Be Overtrading

Forex Investment Myths

I just came across this excellent article on the Forex Capital Markets (FXCM) site discussing many of the dangerous preconceptions that aspiring traders often bring to the currency markets. Here are some of the key points it makes to help dispel these "investment myths":

"One cannot hope to make extraordinary gains without taking extraordinary risks."

"Trading currencies is not easy (if it was, everyone would already be a millionaire)...One must realize that trading takes time to master and there are absolutely no short cuts to this process."

"Most traders...tend to over leverage themselves...and as a consequence, often end up forced to exit a position at the wrong time."

It's well worth a read, whether you're just getting started as a trader or have some experience under your belt -- it's always good to remind yourself of possible biases and bad habits that can adversely affect your trading.