“If you have more than 120 or 130 I.Q. points, you can afford to give the rest away. You don’t need extraordinary intelligence to succeed as an investor”
Warren Buffett.
Forex trading is not rocket science.
A simple set of guidelines can empower aspiring traders to overcome the learning curve and become consistent in a relatively short time. These same guidelines have worked for generations. Back in the early 1900s, Jesse Livermore used the same guidelines to make his fortune. However, many would-be successes have failed for easily understandable reasons.
Most traders fail to respect these basic yet essential rules:
- Follow the trend
- Sit on your hands until there is a trend to follow
- Cut losses as soon as logically possible
- Let winners run as long as logically possible
- Know Your Indicator
In this article, we’ll review the basics to convey how these guidelines keep traders out of trouble.
1. Follow The Trend
“Follow the trend. The trend is your friend”
Jesse Livermore
Most retail traders have trouble following trends. Often, when a trend is developing, retail traders fight it, attempting to pick tops and bottoms. It’s a repetitive habit that a sentiment trader illustrates systematically.
- When there is a defined (evident) uptrend, retail sentiment will be ‘short’ as retail traders attempt to fade the rally.
- When there is a defined (evident) downtrend, retail sentiment will be ‘long’ as retail traders attempt to “catch falling knives”.
Evidently, many traders have trouble identifying a trend. That’s understandable, as depending on how a trader looks at their charts, multiple trends can coexist within the same currency pair simultaneously! It’s rare to see currency trending in the same direction on all time frames. It does happen when momentum is strong or driven by news, but the ebb and flow of the market tends to confuse traders that use multiple time frames.
For example, a currency pair may simultaneously seem to be trending upwards on a daily time frame and trending downwards on a 1-hour time frame. The same pair may also appear to be largely range-bound on a 5-minute time frame.
When trading from the retail angle, keeping things simple is generally best. Here are three suggestions for identifying a trend:
- Stick to a single time frame (usually the daily) for trend identification. The smaller time frames can be used to “zoom in” for better entry and stop placement, but the trend needs to be identified from one primary timeframe consistently.
- Use a sentiment trader and wait until the “crowd” is structurally on the wrong side of a move. When the sentiment trader starts showing readings below 40% (in an uptrend) or above 60% (in a downtrend), a stable trend has likely emerged. Traders must only look for entries in line with the trend.
2. Sit On Your Hands Until There’s A Trend To Follow
“If most traders learned to sit on their hands 50 per cent of the time, they would make a lot more money”
Bill Lipschutz, Market Wizard.
The second essential guideline in trend trading is to “sit on your hands” and refrain from trading until there is a clear trend in place. Of course, there are other ways to trade that don’t rely solely on trends for their edge. However, retail traders often have part-time or full-time jobs, restricting the amount of screen time they can get. Furthermore, the time constraint reduces the available time for pre-trade analysis.
The bottom line is that retail traders are better off being light on their feet. Keep the analysis method simple and keep the trigger criteria equally simple. Trend trading fits the bill because it only takes a few minutes each day to filter the quality trends in the market. It’s key to avoid trading trendless charts where there’s no edge.
3 & 4. Cut Losses as Soon as Logically Possible & Ride Winners
Have you ever held onto a losing trade, thinking that the market “had” to turn around sooner or later? Many traders have been there, but this is in direct violation of a rule we simply can’t ignore: cut losses quickly.
We should always cut our losses quickly. Likewise, we should always hold onto our winning trades for as long as logically possible.
The process of monitoring your trade after the initial entry is called “trade management”. Trade management is an area that is not covered in detail in classic trading books. It’s all about entries and exits. But how do we formulate a plan that helps us cut losses as soon as logically possible, but not sooner? And how can we know when to hold?
The basic idea is to let the market dictate when it’s OK to hold and when it’s time to fold. Simple tools that can help with managing trades are:
- Peak/trough analysis
- Price behaviour
- Common sense
Without a consistent structure for managing your trades, it will be a struggle to keep your emotions at bay and “trade what you see”.
5. Know Your Indicator
“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail”
Abraham Maslow.
Some traders rely solely on indicators such as support and resistance lines. But some traders prefer to overlay technical indicators on their chart to assist with decision-making. That’s fine, but many traders fall into the trap of “covering” their charts with technical indicators without knowing:
- What the indicators indicate
- How the indicators are built
Unfortunately, without knowing this, it’s impossible to use any indicator properly. It’s also hard to know when the indicator might be giving false signals. Technical indicators are just tools. Without a good understanding of what your “tool” does, you won’t know when or how to use it.
Many traders attribute more importance to indicators than they deserve.
To make this point even clear, observe a “Donchian channel”. A Donchian channel simply tracks the highest high and the lowest low of a lookback period. It wouldn’t be any surprise that overbought/oversold readings on the stochastic would be accompanied by “touches” of the Donchian channel. Simply stated, both indicators are telling us when we’re moving outside the range designated by the lookback period!
If you choose to use indicators, make sure you know them inside out. What are they helping you “see”? What is their strength, and what is their weakness?
By learning your indicators inside out, you’ll gain much more insight than by simply overlaying them on the chart and “trusting them blindly”.
What’s Next?
In this article, we revisited five common trading mistakes and offered some easy solutions to fix them. Trading from the retail angle requires clarity of mind. It pays to keep the analysis process simple.
You can keep your trading logical and gain peace of mind when making decisions in the markets by:
- Keeping your charts clean
- Following evident trends
- Sitting on your hands when there are no trends
- Cutting losses quickly
- Letting profits run
- Knowing exactly why you’re using specific indicators
