The following article is perhaps the best I have read as to why the vast majority of traders lose money. It is something I have know for many years but my evidence was based on my own personal experience and the experiences of the traders I have worked with over the last 16 years.
This study was done using a data set of over 12 million live trades from FXCM clients in 2009 and 2010. Amazingly, the average trader won over 50% of their trades! Some pairs generated a whopping 65-70% win rate for clients!
So, what in the world went wrong? Why are the vast majority of their traders losing money?
Read the succinct article HERE
Then, you will see why we do what we do here at MTPredictor. For 10 years this company has been showing traders the importance of risk control, position sizing and having the proper reward side of the equation in place before you enter the trade.
Let me also give you some thoughts on the article based on my own experience in trading and working with traders over the last 16 years starting as a broker with Charles Schwab, mentoring students at my home, developing my own methods and systems, trading live money in real-time trading rooms and my time here with MTPredictor.
The article concludes that a risk/reward ratio of at least 1 to 1 should be used. While a 1:1 risk/reward ration may be acceptable in simulation, it is usually not enough on the reward side of the equation for most traders. Why do I say that? Well, most traders will never be 100% disciplined 100% of the time. We all have lapses in judgement while trading that can lead to greater that 1R losses. Add to this, the fact that we all make mistakes from time to time with our trading platforms. These innocent mistakes can also lead to greater than 1R losses. Further, volatility and unexpected events happen (remember the flash crash?) in the markets all the time. These also can lead (even when proper precautions are taken) to losses greater than 1R (or 1 risk unit).
If the reward side of your trades are only 1 times your initial risk, you can easily dig yourself a hole if any of the above scenarios come to pass. This is one reason why MTPredictor recommends a minimum of 2:1 risk to reward for every trade. This will allow you to make up the losses much quicker than if you use only a 1:1 risk to reward on your trades.
For example, let’s say you start the day off with a nice 1R win of $400. The next trade you get into there is a news announcement that comes out which causes a good deal of slippage in executing your stop loss and turns what should be a 1R loss into a 2R loss. Now on 2 trades you are down $400 or 1 times your initial risk (1R). Out of frustration, you take an ill advised trade. It begins to go against you and you, through a lack of discipline, move your initial stop in the belief that the trade will come back in your direction. It doesn’t. Now, what should have been a 1R loss turns into a 3R loss! You know it happens! You have now lost $1600 or -4R. It now puts you in the difficult position of having to win your next 4 trades in a row just to get back to break even on the day.
Now, lets look at the trader who uses a minimum of 2 to 1 risk to reward on every trade. Let’s say he faces the same situation as the previous trader but did not even start the day with a winning trade. Let’s say he is down a whopping 6R or $2400 on 3 trades. Because the reward side of his equation is always at least 2:1 or greater, it is possible for him to make back the entire 6R loss or more on 1 single trade. Let’s say, however, that his next trade is the minimum 2:1 and he wins on it. He risked $400 but made $800 on the trade. A subsequent trade then sets up that has a target of 5 times his initial risk or 5R potential. It takes a few hours being in the trade but finally pays off at +5R or a profit of $2000. Now, in only 2 trades this trader has not only made back the 6R loss caused by market mishaps and a lapse of discipline and actually profited $400 ($2800 profit – $2400 loss)!
It is much easier from a psychological standpoint to know you can recover from losses like these in 1 trade. It is much more pressure to have to face going on quite a winning streak just to get back to even.
Anyway, hope this helps provide some perspective. Do yourself a favor and start the trading year out the right way. You can try the MTPredictor trading software for stocks, commodities, futures and forex for 15 day at $95 and see how the power of risk, reward and position sizing can turn your trading around. Take the advice that is shared here and in the article (see link above) to put yourself on the right side of the equation and it will go a long way toward you becoming profitable in 2012.
More info about MTPredictor can be found HERE