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.

You can't change the weather

I just came across this line in a good novel I'm reading, "Brooklyn Follies" by Paul Auster. And it struck me as a worthwhile axiom for forex trading as well as lots of other things in life. The best a trader can hope for is not to take the "weather" in the markets personally, and instead adapt tactics and strategy to the current conditions. Carry an umbrella. Avoid puddles. Try not to get splashed by passing cars. Don't get greedy. Use your leverage wisely. Don't trade when it's really weird and nasty out there. That kind of thing.

This quote also got me curious about weather forecasting and how it might compare with market forecasting. They have more in common than you might think:

"Components of a modern weather forecasting system include:

• Data collection
• Data assimilation
• Numerical weather prediction
• Model output post-processing
• Forecast presentation to end-user"

"During the data assimilation process, information gained from the observations is used in conjunction with a numerical model's most recent forecast for the time that observations were made (since this contains information from previous observations) to produce the meteorological analysis. This is the best estimate of the current state of the atmosphere."

All this is from the Wikipedia article on weather forecasting. Worth a read if you find the weather remotely interesting and want to compare/contrast how its forecasters try to predict the future with all the tools and techniques used by traders. I suspect the meteorologists get it right a lot more often than market analysts.

(OK, maybe you personally can change the weather and just aren't telling anyone. In which case, I'll just hope you stay in a good mood.)

**name that Simpsons episode**

Don't Be Afraid to Start Small

Happy 2007! As I head into this new year I've been thinking about how I first got into forex, which was only a year and a half ago, and what advice I might be able to pass on to someone who's put "learn forex" on their list of New Year's resolutions. And one of the first things that came to mind is something I think it's safe to say is on every trader's mind: money.

When I got started, one of the most intimidating things about the forex market for me was the amounts of money involved. Just about any forex tutorial you come across online mentions those trillions and trillions of dollars that flow through the market every day, and if you read enough forex articles and forum posts you'll invariably come across tales of massive bets made by big currency players. And if you read enough of this stuff it's not long before your little stake of a few hundred or a few thousand dollars starts to look pretty puny. It's not the greatest feeling being a very little fish in a very big pond. How are you ever going to turn your tiny forex fund into enough money to retire early, put your kids through college, or buy that solid gold house you've always wanted, as the case may be?

My reply to such monetary anxieties is simple: don't be afraid to start small. In the long-term progress of your forex career, how much you start with is certainly a contributing factor, but it's far, far, far from being the most important one. What's vastly more important is how you manage, allocate, and trade with those funds. Here's why:

• Someone with $500 and a robust, well tested trading system, a highly disciplined approach to trading, and a risk management strategy focused on capital preservation and sustainable levels of risk, can make a lot more in the long run than someone with $50,000 and none of these virtues.
  
  
• Familiarize yourself with fixed fractional strategies for allocating your trading funds. In forex, the potential for compounding your profits is incredible. This is not the 3% in your savings account compounded monthly; depending on your trading strategy, you could be compounding your profits daily or even a few times a day. Play around with some compounding formulas on your calculator, even with very low profit margins and a small starting balance, and the results will get your attention in a hurry.
  


• Leverage: your forex broker will extend you a certain amount of leverage that allows you to make trades with amounts of money several times larger than your actual account balance. So you have more power in the market than you think. But keep in mind this is a double-edged sword, and high levels of leverage enable you to take on high levels of risk. To paraphrase Star Wars, "Use the Force [leverage] wisely, young Jedi!"
  


• Starting small means you won't dig as deeply into your savings (or even worse, go into debt), and having a more modest sum at risk will give you a lot less to worry about as you find your footing as a forex trader. Worrying less means you're less likely to panic when things go wrong. And being less likely to panic means you'll make better trading decisions.
  
  
• Remember learning to swim? The shallow end was always the safest place to get your feet wet for the first time. The same goes with forex. It's much better to learn good trading habits with a small forex fund than make a huge deposit and go doggy-paddling into the deep end on your first day.
  
  
• Your funds are a trading tool, just like your charts and the indicators you choose to display on them. Your main focus should be on using them intelligently and consistently - not on how many there are, how cool they look, or how many monitors they're displayed on.
  

How do I know all this? Well, I started small myself, and knowing what I know now (which is not a lot, but it's not nothing, either) I'd definitely start that way again.

Happy New Year - hope yours is a prosperous one!

My trading gurus, The Simpsons

If you've read this blog for at least a couple days you'll know that a subject I tend to revisit ad nauseum frequently is the importance of limiting your emotional involvement with the market. Getting too caught up in a particular trade or obsessively watching for new trade opportunities at all hours can lead you into a costly spiral of overtrading, second guessing your trades, trying to recoup losses by taking on excessive risk, and making yourself thoroughly miserable and possibly broke in the process. To avoid this type of addictive overinvolvement, one of the trading strategies I try to follow is the Fire-and-Forget Principle, in which all the key parameters of a trade are set beforehand, allowing the trader to just walk away until the trade completes itself.

Easier said than done, right? Because it's so tempting to keep checking on your trade once it's in progress, and if it's not working out, it's even more tempting to try and fix it. You know, move that stop-loss up a bit, or maybe move it down so the trade has more room to breathe, or how about just close it early and trade in the opposite direction? Once you've committed to firing and forgetting, how do you avoid falling into this trap? Well for me, that's where The Simpsons come in.

One of my favorite Simpsons episodes is a Halloween special called "Attack of the 50 Ft. Eyesores" in which a lightning storm causes giant advertising icons to come to life and rampage around Springfield (the Simpsons' hometown, for you Antiques Roadshow watchers out there). Desperate to stop the destruction, Lisa Simpson consults an advertising executive who explains that the marauding eyesores will lose their power if no one looks at them. To get the point across he then writes the following jingle, which is memorably sung to the townsfolk by Paul Anka:

To stop those monsters 1-2-3
Here's a fresh new way that's trouble free
It's got Paul Anka's guarantee...
[Lisa]
Guarantee void in Tennessee!
[All]
Just don't look!
Just don't look!
Just don't look!
Just don't look!

Well, the same idea goes for your current trade. To prevent it from becoming a monster that takes over your day, week, month, etc., take a break and do something else for a while, like go get a donut. (Sorry, all the donuts in this episode must've gotten to me.)

In all seriousness, the Simpsons' point is an important one: we grant psychological power to things by choosing to pay attention to them. By the same token, we can reduce their power over us by choosing to limit that attention, especially when it serves no good purpose.

OK, now that I've beaten that point into the ground, here's the episode in question, courtesy of YouTube:



Related topics:
Limiting your emotional exposure to the markets
The Fire-and-Forget Principle

What's the biggest thing you've ever thrown after a losing trade?

Being human, I usually get seriously annoyed after a trade goes the wrong way...I haven't thrown anything yet, but I have been known to mutter and curse angrily at my screen, the cat, my coffee, and anything else that happens to be in the room. Forex trading can be a pretty solitary pursuit, and as a result you can sometimes feel like the only person getting frustrated by the market...so it's always good to get some perspective and realize you're not the only one with issues. As Rich over at Forex Project pointed out this week, even the experts don't always make a killing.

The reason I ask about the throwing is because I was reading about a noted stock picker you've probably heard of because he's all over the place. I'm not going to name him because (a) guessing games are fun and (b) I don't want him throwing anything at me. But according to his Wikipedia bio, during his days running a (very successful) hedge fund he was noted for throwing telephones and computers around the office when the market wasn't going his way. (Not sure if they were laptops or desktops. Maybe Bloomberg terminals?) And this guy is one of Wall Street's great success stories.

So while I'm not recommending throwing heavy objects around the room, and while I still think it's wise to avoid getting too emotionally involved in the market, I also realize it's almost impossible to achieve perfect detachment and not get a bit worked up about a bad trade. Don't beat yourself up for being human...just try to learn from the experience. And who knows, maybe someday you'll have your own TV show.

Related topic:
Limiting your emotional exposure to the markets

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

Charts vs. No Charts: A Thought Experiment

This is a topic I revisit periodically because I think the ways that traders interact with their charts raise all kinds of important issues in trading discipline and execution. First off, I should state my own bias: I look at charts every day, primarily a candlestick / moving average / Bollinger Band combination, but I don't make trading decisions based on them. They're fun to look at, always fascinating, but for me, also dangerous. My worst trading decisions were all made based on charts because, as I've written before, they can be very deceptive. On the other hand, some of my best trading ideas came from looking at charts; however, their development and execution all took place on spreadsheets. In fact, all my current trades are identified by equations run through an Excel spreadsheet, and I could spend my entire day without looking at a chart once and it wouldn't affect my trading activity. I'd probably just get a little bored without any pretty candlesticks to look at.

So that's the background for the thought experiment I came up with. (In case you're wondering what I mean by "thought experiment," here's an excerpt from the Wikipedia definition: "A thought experiment in the broadest sense is the use of an imagined scenario to help us understand the way things really are. The understanding comes through reflection on the situation...Thought experiments are well-structured hypothetical questions that employ 'What if?' reasoning.")

Now here's my "What if" question: What if two traders of similar experience and temperament traded the same currency pair using exactly the same trading indicators for exactly the same period. However, one trader makes all his trading decisions based on the indicators depicted on a chart. The other trader doesn't look at a chart once, but responds to the same signals identified by equations in an Excel sheet or comparable software. After an initial trial period, the traders would then switch places and trade using the other system for the same period of time. This way both traders would have used both systems, providing a more balanced set of data to draw conclusions from.

At the end of these test periods, what would the trading results look like? Would the charts have enabled the traders to make decisions with better market context and understanding of the larger trends at work...or would they have led to confusion, indecision, and losses as the traders got caught by deceptive patterns, jumped to conclusions about where an indicator was heading, or delayed their trades because of contradictory visual cues?

And over at the chart-free trading desk, would the traders have benefited from the strict Yes/No answers this more mechanical system would generate? Would they place their trades more precisely and exit them with more discipline and less second-guessing? Or would they have gotten bored by the relative lack of discretion allowed them, along with the absence of interesting visuals, and gotten sloppier in their trading as a result? Or maybe during the stress of a losing streak, they'd have begun doubting the integrity of the system without a chart to reassure them that their indicators were valid.

Of course, the ultimate deciding factor would be the total profits (or losses) resulting from each system. So which would win? You can probably figure out my answer - feel free to leave yours in the comments below!

Related topics:
Don't let your charts deceive you
The perils of chart burnout
Know your candlestick patterns

Keeping Your Current Trade in Perspective

If you're like me and get overly involved in the outcome of each and every trade, it's useful to keep certain things in mind to avoid becoming obsessed, upset, or both by what's happening with your current trade at this very moment. Or now. Or...now. Because while every trade is important, in the overall success of your trading system a single trade will not make or break you. Nor will a series of them, if you're managing your risks well. Here's what I remind myself when I find I'm getting riled up by a particular trade that's not going my way:

• Every system fails some of the time.
  
  
• If your system works consistently, the failure of a single trade will have a negligible outcome on its long-term success. In fact, in a system designed for the long haul, a single trade represents a mere fraction of a percent of the final outcome.
  
  
• So this day went badly. You'll just have to tack another day onto your trading career. If you don't feel like you have an extra day to spare, you should probably exercise more.
  
  
• If you're compounding your gains and risking a fixed fraction of your funds in every trade, the dollar sizes of your losses will increase as your funds increase. If you're getting upset over how big a loss looks in dollar terms, remember it would be a lot smaller if your system wasn't working.
  
  
• The fact that a trade's going wrong is trivial. The fact that you're worrying about it constantly is the real problem.
  
  
• This happened 10 times last month and you still made a nice profit. So calm the hell down.
  

On the other hand, if you have no system or context within which to place a particular trade, you have much bigger problems than that one trade: in fact, you probably shouldn't be trading at all until you have a strategy that provides the necessary rules, risk management, and long-term perspective that are essential to a successful trading career.

So let's say you have such a system in place - when should you be concerned about the results of a single trade? Surely there's some point at which it matters? In my opinion, that point is reached only when a trade is part of a continuing negative pattern that varies significantly from your system's expected outcomes. The time to take notice is when events that should be statistical outliers start happening with unusual frequency. For instance, if your system's expected success rate is around 60% and you've just had 10 failed trades in a row, that's unusual: the odds of it happening are around .004%. In a case like this, I'd tow my leaking system back to harbor and put it in drydock to see where the hole is and if it looks fixable. (Sorry, that nautical metaphor sort of got away from me. But you get the idea, matey. Arrr...)

Related topics:
Limiting your emotional exposure to the markets
Sticking to your trading system

Interpreting Market Reactions to Non-Farm Payroll (NFP) Numbers

As I've noted before, I don't trade news events like the Non-Farm Payroll. One of the main reasons is that I prefer to be asleep when most of them happen. Another big reason is that I find it difficult to interpret what they mean in the 10 seconds or so you have to make that decision and place a trade. So if I ever do trade the news in a serious way it'll be on an entirely automated basis with FX Engines.

But that's doesn't mean I ignore these events entirely, and a recent email from a reader got me thinking even more than usual about the NFP report. The reader was curious about why the dollar strengthened after weaker-than-expected employment numbers, which I thought was an excellent question, and tried to answer as best I could. Here's our Q & A exchange about what it all means:

Q: "I am very confused with Friday's dollar action. The NFP report seems negative to me, no matter how you look at it. If the consensus was 120k and the actual figure is 50k... well that's a huge decrease to the negative side. Then, it was explained to me that the previous month's numbers were inaccurate and the two months averaged together equates to 120k. Again, this to me is negative for two reasons.: 1, last month's report was wrong = negative 2. if last month's number was actually much higher than 120k than the drop from last month to this month at 50k would be even worse!

Yet the dollar strengthened. I am confused. If you could share your thoughts on the event, if would be greatly appreciated."

A: "Frankly, I usually find market reactions to the NFP and other events pretty confusing too, which is why I generally stick to statistical and technical analysis of price movements (if X and Y happened today, Z will happen tomorrow 60% of the time, etc.)

However, in this case I think I know why the dollar strengthened: higher employment tends to be correlated with higher inflation, and inflation has been a big worry in the markets lately. The closer the economy is to full employment, the higher the upward pressure on prices as consumers have more in their pockets to spend. This relationship is known as the Phillips Curve.

On the flip side, slowing employment growth actually helps reassure traders that inflation is under control, which leads to greater confidence in the dollar. This also leads traders to conclude that the Fed is less likely to raise interest rates to control inflation, and might even start lowering them again - another big reason to buy the dollar.

However, this doesn't mean the market will have the same reaction down the road. If a future NFP report showed continued weak employment and inflation had ceased to be much of a concern, I wouldn't be surprised if traders began to have more serious concerns about the fundamentals of the US economy and the dollar weakened as a result. Market reactions to news events are highly dependent on the context within which the events occur, so the same news could produce wildly different reactions in different contexts."

That's my amateur interpretation, at least...what's yours? I'd be very interested to hear how other traders interpret the NFP, so feel free to post your analysis in the comments below!

Related topics:
Why I don't trade on economic news
FX Engines launches news trading tools

Related links:
Non-Farm Payroll Report
Phillips Curve
FX Engines

Words to Trade By

I just finished a great book by one of my favorite authors, Cormac McCarthy. It's called "No Country For Old Men" and is a chronicle of violent crime and drug running set in the Texas border country. McCarthy often gives his most troubled and troubling characters the best lines, and he's done it again with the arch-villain in this book, Anton Chigurh.

When I read the following quote by Chigurh, it immediately struck me as an insightful description of why people fail at certain ventures - that part of their character or temperament that causes them to overextend themselves, take on too much risk, and lose everything. And I think it applies especially well to trading (finally, the connection to forex!):

"Not everyone is suited to this line of work. The prospect of outsized profits leads people to exaggerate their own capabilities. In their minds. They pretend to themselves that they are in control of events when perhaps they are not."

Ever had that feeling? Me too.

So if you enjoy a good, tightly-written, philosophical crime thriller this might be the book for you. It's a tale where even the bad guys are worth listening to, as long as you keep a safe distance.

Related links:
Cormac McCarthy
No Country for Old Men

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

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.

Trading at all hours? Get some sleep!

One of the challenges I faced when I first ventured into the forex markets was the fact that much of the real action took place while I was asleep, or at least extremely groggy and sluggish. I'm on the West Coast of the US, and when New York and London trading is in full swing, I'm usually not in a state to make good trading decisions. At first I tried to shift my sleep schedule around, either staying up extreeeeemely late to join some of the early trading activity, or getting up far earlier than I would otherwise have considered sane or healthy to trade the tail end of the London-New York overlap.

The results of these sleep deprivation experiments (because that's really what they turned out to be) were a mounting series of losses, a growing coffee dependency, and a marked increase in my daily crankiness levels. As a rule of thumb, if you're trading while half-asleep, odds are you're not trading well.

Sleep deprivation being the mother of invention, I was driven to find a new forex strategy that would allow me to get a decent night's sleep. The keys to this new strategy were:

(a) Expanding the timeframe I traded in from a few hours to increments of a day or multiple days

(b) Designing market predictions that would trigger trades at hours when I was normally awake - specifically, in the 4:00 pm to 5:00 pm window, Pacific Time.

(c) Investigating automated trading systems such as FX Engines that would enter and exit trades for me no matter what my state of consciousness. I now use FX Engines constantly in combination with strategies (a) and (b).

(d) Limiting the amount of time I spend directly involved with the forex markets: staring at charts, monitoring trades, panicking about my trading strategy, and so on. This helps ensure I don't end up tracking my trades obsessively into the wee hours. (Though as I noted in this post, I'm still not limiting my involvement in as disciplined manner as I should. My trading discipline is still very much a work in progress!)

So if you're facing a choice between sleep and forex, fear not -- you can design a profitable strategy that allows you to have both.

Limiting your emotional exposure to the markets

Lots of advice about the forex markets focuses on how to manage your funds, limit your trading costs, and make careful use of your margin when trading. In fact, my previous post was all about that kind of stuff. And it's important. But equally important to a successful trading career (or hobby) is managing how the market affects your emotions - because it can take quite a toll when things aren't going your way. If forex is seriously affecting your quality of life, you absolutely must reassess how you're approaching the markets.

In my own trading, I've noticed that the negative impact that bad trades have on my emotions and mental outlook tends to be amplified by a set of bad habits. To the extent I can recognize and control these habits, I can limit how emotionally draining a bad week in the forex markets can be.

One of my worst habits is checking on my trades too often. The way I've structured my trading system, I really shouldn't need to check on my trades more than a couple times a day - in fact, I could probably manage with just once a day. But that doesn't stop me from taking a peek dozens of times in a 24 hour period. And there's no point to checking, other than to satisfy my own nagging curiosity, because my system only permits trades to be executed once a day, at a very specific time of day.

Inevitably, when I check in on a trade at a time I really don't need to, it's often not going the way I expected, and I start to get upset. I start to think I need to bail out before it gets even worse. I start thinking in an extremely short-term timeframe completely at odds with my strategy, which seeks gains over months and years of trading. I start to forget that I trade the odds, and there are no 100% odds in forex. I start to question the basic tenets of my trading system. All my trading discipline starts to erode as I begin to second-guess my strategy.

Maybe this sounds familiar. So, you may ask, how can a trader avoid this vicious cycle of checking, doubting, rechecking, doubting some more, and undermining the entire trading system they've put so much work into? The simple answer is to deliberately limit your access to the market. Because looking at it too often can cause serious burnout, as I discussed in this earlier post. Set aside just a few times a day (or whatever period you trade in) when you're allowed to look at your trades. Whenever you're tempted to check in on them outside those times, remind yourself of more productive ways you could be using the time: using historical data to discover new signals, reading about new forex strategies, having a beer outside on the patio, whatever helps divert you from that insidious urge to know exactly what each trade is doing minute by minute. If you can curb that habit and start making better use of all the time you freed up, chances are you'll end up being a much better trader.

Related topics:
The Perils of Chart Burnout
Signs You May Be Overtrading

Sticking to your trading system

One of the hardest things to achieve as a forex trader, at least in my experience, is a level of commitment to your trading strategy that allows you to trade consistently throughout a stretch of losing trades. Every system I'm aware of inevitably generates losing trades, and there's nothing that will sap your confidence in your trading plan than watching your funds trickle (or gush) away day after day.

Since every system needs consistent execution over time to prove itself, bailing out at the first sign of a losing streak, or switching nervously between different systems in a quest for one that's fail-safe, is a great way to wreck your forex career in a hurry. It's important that you give your system a fair chance to succeed before tossing it in the trash, reworking it into something completely different, or moving on to the next great strategy.

Now I'm not saying you should go down with the ship, tossing all your funds overboard on a system that's clearly and consistently failing. But I am recommending that you strike a balance between the importance of long-term consistency and the anxiety of short-term risk aversion. It is entirely possible your system is fatally flawed, and you just don't know it yet. It is also entirely possible that your system is a winner...and you don't know that yet, either. One way to build your confidence in your system's performance over time is through extensive backtesting. Remember, the data is your friend. Testing past trades using historical data will show you the worst drawdowns your strategy has produced, as well as its greatest winning streaks.

But let's say you've done all the above -- thoroughly backtested your system, traded consistently for several weeks, put aside those inevitable panicky reactions and stuck to your trades, and you're still faced with mounting losses. How do you know when to bail out and go looking for a better forex philosophy? One approach is to compare your current losses with the worst drawdowns in your historical testing. Are your losses of a similar magnitude? Are they even larger than those in the backtests...25% greater, 50% greater? I'd say if you're getting into a range with losses are over 50% greater, it's time to start dusting off Plan B. And it's always important to have a Plan B, and a Plan C...just as long as you're not switching between them on a daily basis out of panic or desperation. The forex markets are not known for rewarding either of those qualities; quite the opposite.

Remember, this is all just my opinion, and how useful my advice is to you will undoubtedly vary depending on your risk aversion or tolerance. But I do think it's important to keep in mind, no matter how you trade, that any trading system will (a) generate losses and (b) require consistent execution over time to prove its worth.

Disagree? Then please say so in the comments!

The Perils of Chart Burnout

One thing I discovered after hours of staring at candle charts, CCI graphs, stochastics, Bollinger Bands, Stark bands, moving averages, Parabolic SARs, and a variety of other more exotic charts and signals was that, no matter how much visual information I had in front of me, I still wasn't able to predict the future with much accuracy. In fact, I noticed my predictions got progressively worse the longer I watched the markets on a minute by minute basis, and the more charts and signals I looked at.

When you're just getting started as a forex trader (and I still consider myself a newbie) it's easy to confuse a lot of information with a lot of certainty, and a lot of cool charts and nifty signals with high trading odds. In some cases this may be the case, but all too often, especially for beginners, it's easy to get swamped with data and begin thinking that you're seeing patterns and trends that aren't there. The fact is, most of the 50 different signals you're looking at are really just variations on the same theme -- a change of price direction, a breakout, an emerging trend, a statistical anomaly, an oversold or overbought condition, and so on. For example, when I realized that the CCI graph was describing the same price behaviour as one moving average crossing over another and then approaching and rebounding off the Bollinger Bands, I felt more confident in being able to look at fewer charts and still receive the same information.

In addition to getting burnt out looking at too many different charts, you can burnt out looking at them too long. There are long periods when there's just not much going on in the markets, and you'll only drive yourself loopy staring at a chart at those times waiting for something to happen. If you can identify the really important periods and confine your attention to those, you'll avoid hours of frustration when the charts aren't describing much of anything. You'll also avoid the risk of jumping on a false signal that looks like the real thing but leads nowhere, which are common during periods of low market activity.

Another problem with charts, which I alluded to earlier, is that they can give you the illusion of certainty. Here's one example I was often guilty of -- for a while, I was absolutely sure I knew what would happen when the price crossed above or below a Bollinger Band. After trending up or downward for a while, it would obviously have to bounce back above or below the band and head in the opposite direction. Right? Well, yes, eventually that's usually what happens. But when you're constantly looking for that "Bollinger bounce," it's very easy to start filtering all the incoming information to point exclusively toward that bounce. And if you're like me, you may then overinterpret one of these signals, make an impulsive prediction, and trade on it. You may then discover, as I did on numerous occasions, that what looked exactly like the beginning of a rebound up or down may in fact be part of a minor holding pattern until the price continues its original trend, leaving you sputtering as your stop-loss gets vaporized.

The lesson that you'll eventually learn, if you're paying attention to all the money you're losing, is that it's impossible to know for sure, and very often you'll get it wrong. That's the key fact here: very often you'll get it wrong. If you can't accept that you'll get it wrong, or that you'll have to wait longer than you expected to be proved correct, then charts aren't going to help you. What will help you is adjusting your expectations, and realizing that staring at a chart 12 hours a day may in fact be as harmful as it is helpful. The more data you have to interpret, reinterpret, second-guess at, third-guess at, and lose sleep over, the more likely you are to resort to wishful thinking, trade out of boredom or desperation, hang on to bad trades too long, and end up blowing your whole account at 2:00 in the morning. In short, the more likely you are to get burnt out or burnt up.

These days I look at charts for maybe 15 minutes a day. I spend far more time working with Excel sheets of price data, testing potential signals, looking at long-term trade statistics, and developing simple yes/no, short/long indicators and entry points that allow me to place trades and then leave them alone for hours or days. Oh, and I still spend quite a bit of time playing with FX Engines, which allows me to do all of the above on a highly automated basis.

Perhaps most importantly, I get far more sleep and feel much less anxious about my trades than I did when I was staring at charts all day (and much of the night).

Related topic:
Limiting your emotional exposure to the markets

Creating "Flash Cards" to Improve Your Trading Skills

One strategy I've pursued in the never-ending quest to improve my trading skills is creating flash cards from screenshots of forex charts. These cards can help remind you of the key factors in winning (and losing) trades, so you get better at recognizing these patterns the next time they show up. Many successful forex traders reap their profits using finely-honed pattern recognition skills; in fact, this may be the most "intuitive" way to trade forex, and the more practice you get recognizing the right patterns, the better your odds are likely to be. Over time, your collection of forex flash cards will become an in-depth visual record of your trading history that you can for valuable insights.

Below are some examples of screenshots I took following winning and losing trades. This one shows the 5-minute CCI (Commodity Channel Index) and candlestick chart with 5 and 20 unit moving averages that I had open when I made a successful 8 pip short trade of the EUR/USD in August 2005:



And below we see an unsuccessful attempt to trade the EUR/USD short, using only the 5-minute CCI chart (I was using Woodie's CCI system at the time):



In this case, the clear lesson is that what seems like a valid signal -- that little downward spike the lower arrow is pointing to -- can often turn around in an instant and become a false one that loses you 11 pips and leaves you shaking your head in exasperation. In fact, this is a perfect example of the type of losing trade that eventually made me swear off the 5-minute chart entirely. Ah, memories.

All of these screenshots were taken on a rather geriatric Dell PC from the charts on Global Forex Trading's DealBook software. First, I'd hit the "Print Screen" key to capture the screen image I wanted, then I'd paste it into my Microsoft Paint program and crop it down until it just displayed the chart images I wanted. After that, I'd save the images into either my "Good Trades" or "Bad Trades" folder, and voila, my digital flash cards were complete. I could easily review them on screen, or print them out if I wanted a hard copy as well. On some of the cards, I'd also type in a few comments about the circumstances surrounding the trade -- whether I'd waited too long to enter or exit, whether I'd been indulging in an excess of wishful thinking (I usually had), and anything else relevant to that particular gain or loss.

If you're a chart-based trader, you may find these types of flash cards a valuable addition to your arsenal. They're a convenient record of what worked for you and what didn't, and by looking at them on a regular basis you can begin to intuitively recognize the patterns that will make or lose you money.