Why Do Many Forex Traders Lose Money? Here is the Number 1 Mistake

Data source: Derived from data from a major FX broker* across 15 most traded currency pairs from 3/1/2014 to 3/31/2015.

The above chart shows results of over 43 million trades conducted by these traders worldwide from Q2, 2014 through Q1, 2015 across the 15 most popular currency pairs. The blue bar shows the percentage of trades that ended with a profit for the trader. Red shows the percentage of trades that ended in loss. For example, the Euro saw an impressive 61% of all trades closed out at a gain. And indeed every single one of these instruments saw the majority of traders turned a profit more than 50 percent of the time.

If traders were right more than half of the time, why did most lose money?

Average Profit/Loss per Winning and Losing Trades per Currency Pair

Why Do Many Forex Traders Lose Money? Here is the Number 1 Mistake

Data source: Derived from data from a major FX broker* across 15 most traded currency pairs from 3/1/2014 to 3/31/2015.

The above chart says it all. In blue, it shows the average number of pips traders earned on profitable trades. In red, it shows the average number of pips lost in losing trades. We can now clearly see why traders lose money despite being right more than half the time. They lose more money on their losing trades than they make on their winning trades.

Let’s use EUR/USD as an example. We see that EUR/USD trades were closed out at a profit 61% of the time, but the average losing trade was worth 83 pips while the average winner was only 48 pips. Traders were correct more than half the time, but they lost over 70% more on their losing trades as they won on winning trades. The track record for the volatile GBP/USD pair was even worse. Traders captured profits on 59% of all GBP/USD trades. Yet they overall lost money as they turned an average 43 pip profit on each winner and lost 83 pips on losing trades.

So what is the major problem?

The problem is that traders don’t let their profits run.

The solution is simple:

Cut Your Losses and Let Your Profits Run!  But why is this difficult to do?

It is difficult to do because we are not aware of our emotions the majority of the time.  When trades are in a profit, the greed comes into play because they want to make money now.  When trades are at a loss, the ego of righteousness comes out hoping that the trades will reverse to their favor.

For each and every trade, there are different factors that needs to be considered.

They are:

  1. Before you execute, do you have a proper, detailed trading plan?  The plan would include, entry points, stop loss points, target points, money management, risk management, the probability of winning of the trade, defensive strategies, offensive strategies, the emotional factors before trading.
  2. Trade Management.  How solid is your trading management skills? Is your trading plan still within the criteria of the trade?
  3. Traders Experience through Technical and Mental Conditioning
  4. Traders level of skill derived from knowledge and practice
  5. Does the trader have a coach

Based on my experience as a peak performance trader coach, one of the major causes of why traders lose is because they don’t have a plan.  They don’t have a coach as they have learned how to trade by themselves.  They have created a lot of bad habits and the system they use is not in-sync with their personal behavior.  Lastly is the lack of mental awareness.

Here are some steps I recommend how to cut your losses.

  1. If you traded without a trading plan due to anxiety, impulsiveness, and fear of missing out, acknowledge the mistake, accept it and close your position.
  2. If a trade is in your favor, let it run.  Average up and never average down! Have a profit maximizing strategy.
  3. Be patient and be disciplined with your trading plan!  Remember that Patience is a virtue!

The other common mistake of traders is not paying enough attention to the probability on Risk to Reward Ratio.

Prospect Theory

Let’s play a simple game.  You have two choices.  Choice 1 means you have a 50% chance of winning 1000 dollars and 50% chance of winning nothing. Choice 2 is a flat 450 point gain. Which one would you choose?

Expected Return

Gains

Choice 1

50% chance to Win 1000

50% chance to Win 0

Expect to win $500 over time

Choice 2

Win 450

Win 450

Over time it makes sense to choose Choice 1—the expected gain of $500 is greater than the fixed $450. Yet many studies have shown that most people will consistently choose Choice 2.  Let’s flip the game and run it again.

Expected Return

Losses

Choice 1

50% chance to Lose 1000

50% chance to Lose 0

Expect to lose $500 over time

Choice 2

Lose 450

Lose $450

In this case we can expect to lose less money via Choice 2, but in fact studies have shown that the majority of people will pick choice 1 every single time.

Here we see the issue. Most people avoid risk when it comes to taking profits but then actively seek it if it means avoiding a loss. Why?

Losses Hurt Psychologically far more than Gains Give Pleasure – Prospect Theory

Nobel prize-winning clinical psychologist Daniel Kahneman based on his research on decision making. His work wasn’t on trading per se but clear implications for trade management and is quite relevant to trading. His study on Prospect Theory attempted to model and predict choices people would make between scenarios involving known risks and rewards.

The findings showed something remarkably simple yet profound: most people took more pain from losses than pleasure from gains.

It feels “good enough” to make $450 versus $500, but accepting a $500 loss hurts too much and many are willing to gamble that the trade turns around.

This doesn’t make any sense from a trading perspective—500 dollars lost are equivalent to 450 dollars gained; one is not worth more than the other. Why should we then act so differently?

Prospect Theory: Losses Typically Hurt Far More than Gains Give Pleasure

Why Do Many Forex Traders Lose Money? Here is the Number 1 Mistake

Taking a purely rational approach to markets means treating a 50 point gain as morally equivalent to a 50 point loss. Unfortunately our data on real trader behavior suggests that the majority can’t do this. We need to think more systematically to improve our chances at success.

Avoid the Common Pitfall

Avoiding the loss-making problem described above is very simple in theory: gain more in each winning trade than you give back in each losing trade. But how might we do it concretely?

When trading, always have a profit maximizing strategy.  Take some profits along the way and leave some if the price is still within the direction.  Keep trailing your stop and eventually you will have zero risk and infinite rewards.

If you follow this simple rule, you can be right on the direction of only half of your trades and still make money because you will earn more profits on your winning trades than losses on your losing trades.

What ratio should you use?  It depends on the type of trade you are making.  It also depends on the the probability of the trade.  We recommend to always take a minimum probability of winning of 80%.   What does this mean?  It means that each and every time you trade, the price will only go in 3 different directions.  Up, Down, or Sideways.  Eventually, either it will go up or down.  So, the question is, where will the direction of price go first?  If you can determine the probability of where the direction will go towards your target point, you then can create your probability to reward vs probability to risk ratio.  

Therefore, only trade with high probability set-ups!

Stick to Your Plan: Use Stops and Limits

Once you have a trading plan that uses a proper reward/risk ratio, the next challenge is to stick to the plan. Remember, it is natural for humans to want to hold on to losses and take profits early, but it makes for bad trading.  You must overcome this natural tendency and remove your emotions from trading. The best way to do this is to set up your trade with Stop-Loss and Limit orders from the beginning.

The most important part in this process is to be honest to yourself if you are willing to ACCEPT the risk.  If so, then take full responsibility of the trade.  If you do this process, it is automatic that any type of emotion of fear will dissipate.

The next step is to always trail your stops when your trade is in your favor.  This will reduce the risk and maximize the return.  Have a good profit maximizing strategy.  Risk and Money Management is imperative to each and every trade.  Successful traders do not get it most of the time however, they have very good money management and risk management.  They cut their losses quickly and let their profits run.  In the end, they are still profitable in their trading.

In conclusion:

There is no easy way out to be a consistent, profitable trader.  It takes time and money.  It is important to get educated properly, practice what you have learned, and be coached technically and psychologically.  Successful traders have a plan and are very meticulous with their planning.  They have the ability to control their emotions and trade with no ego.  They cut their losses short and let their profits run.  They have a good solid trading method that involves good high probability set-ups, stops, and profit maximizing strategies.

If you have any questions regarding this article, please do not hesitate to email me at contactus@estetrader,com.  If you need assistance or want to learn the process to be a consistent, profitable trader, please do not hesitate to email me or call me directly at 650 390 7104 for a free consultation.