3 Lethal Mistakes Which Could Sink Your Trading Account… In No Time
Eric Furstenberg • 8 min read
I bet you’ve heard of people who got their fingers burnt with forex trading. These people will often refer to forex trading as being extremely risky and unpredictable. I have even heard one guy saying it’s a form of gambling. Well, most (if not all) of these people didn’t have any clue of how to apply proper risk management. The ones that knew something about managing their risk didn’t adhere to their own rules, or only applied them for a short while. Of course, there are many other factors besides risk management that determine a trader’s success, but without proper risk management, your chances of failure are basically guaranteed.
You see, trading the forex market and other markets is an enormous challenge to the average person. The emotional aspect of trading is probably the greatest challenge you will need to overcome on your way to success. When the waves of fear and greed beat vehemently against your trading ship, you need to maintain a controlled and disciplined approach in order to make it through the storms. Unfortunately, it takes many voyages across perilous oceans for the ‘average Joe’ to learn how to control himself, his emotions, and his trading. Before you can master the markets, you need to master yourself.
Let’s take a look at three of the most lethal snares you need to avoid in your trading:
Snare No. 1 – Using Too Much Leverage
When I first heard about trading with leverage, I thought: “Wow! This is awesome!” And of course, it is awesome, but extremely dangerous if you don’t know how to use it properly. You see, the smallest position you can typically open when you’re trading forex is a micro lot, which is 1000 of a currency pair. Without leverage, you would need more than a thousand dollars to open a 1K position on the EUR/USD. Then you’d need additional funds to sustain the trade in case you experienced a drawdown. Of course, the moment you open a trade, you’re immediately drawn down because of the spread.
Anyway, with leverage of, let’s say, 1:100, you need less than $11 to open a trade on the EUR/USD. This makes FX trading much more viable for investors and traders with small accounts. Let’s say you’d like to open a trade on the EUR/USD with a stop loss of 50 pips and a take profit of 100 pips. The amount you need to open a 1K lot is about $11. Fifty pips is $5 when you trade this lot size. So, to maintain your trade up to the point where your stop loss gets hit, would require about $16, which is really a minute amount. Of course, you can’t trade effectively with a $16 account, this is just a practical example to point out the difference between a leveraged account and a ‘normal’ unleveraged account.
This is where inexperienced traders get carried away by excessive greed. They think about it this way: “I’m going to make a massive return on my investment by going BIG! With my $500 account, I can easily open a 25K trade. If I hit a 100 pip target with 25,000 of the EUR/USD, I’ll have a magnificent profit of $250. I can make a 50 percent gain on my investment in no-time. I can’t wait to place the trade.” The naive trader spots a setup on the EUR/USD which looks like a pretty good opportunity and pulls the trigger, confident that he’s only a few hours away from a massive 50 percent gain on his account. Does this sound familiar?
Let’s say this inexperienced trader placed this trade with a 50 pip stop loss and a 100 pip take profit and lost the trade. That would be a loss of no less than 25 percent of his whole account. Of course, he could have won the trade, but we know that even the best trading opportunities can turn into losing trades.
Now let’s say this same trader plucked up his courage and placed another trade, but this time, a smaller 20K trade with a 70 pip stop loss and a 140 pip take profit, risking $140. If he lost the second trade as well, he would only have $235 left of his original $500. That’s a loss of 53 percent in only two trades! Do you see how dangerous excessive leverage can be?
Now that we know we shouldn’t use too much leverage in our trading, how much leverage would have been appropriate for this trader with his $500 account? Well, no matter what the size of your account is, you shouldn’t risk more than about two percent of your equity on a single trade. For less experienced traders, I would recommend risking one percent or less. Of course, traders with no experience at all should first try it out on a demo account.
So, with a $500 account, a 50 pip stop loss on a 1K EUR/USD trade would be 5 dollars’ risk, which is 1 percent of the total equity. Remember, the minimum amount required to open and maintain a trade up to a drawdown of 50 pips (with a 1K lot size) is $11 + $5 = $16. Subtract this from $500 and you get $484. Divide $484 by $5 and you get 96.8. This is the number of times you can lose one percent of a $500 account before you don’t have enough funds left to place another trade. Let’s round that number down to 96 (because 0.8 trade = no trade). Amazing, isn’t it?
Now let’s assume you have a forex trading strategy with a 55% win rate. Let’s keep it simple and work with a stop loss which is equal to the take profit. Now, if you would risk 25% of your whole account on one trade, you could obviously wipe out your account easily. After all, it would only take four losing trades to wipe out the account (this might not make sense to you at first glance, but it is possible by means of adjusting the stop loss distance in pips, to accommodate the smaller lot size you would need to match with your diminished equity levels, with the last one or two trades).
With a strategy that yields a win rate of 55%, you could easily lose four trades in a row. However, this same strategy will rarely lose 20 times in a row, much less 40 or 50 times.
Statistically calculated with a special risk of ruin formula, you stand a 13% chance of blowing your entire account with a win rate of 55% if you risk 10% of your account on every consecutive trade. When you risk only 5% per trade, this number falls to 1.8%. But when you risk only 2% per trade, your chance of blowing your whole account is reduced to zero. In these three examples, a reward-to-risk ratio of 1:1 is implied. Remember, we’re talking about exactly the same win rate (55%). The only difference is the percentage of your equity risked on each trade. Of course, the results vary when you adjust the win rates and the reward-to-risk ratios, but with all the different inputs, the principle remains the same – risking a smaller amount of your equity at a time reduces your risk of ruin (ROR) dramatically. Never use excessive leverage!
Snare No. 2 – Revenge Trading
This is one of the most dangerous games you can play with your money. Without a disciplined trading approach, you will not make money in the long run.
Many traders can’t handle losing, which ultimately drives many of them to revenge trading. Sometimes they can handle one or two consecutive losing trades, but when they lose too many times in a row, they become furious and try to win back all of these losses with one trade.
The Nature of a Revenge Trade
When these traders go on to place this ridiculous next trade, they are so overwhelmed by their own emotions, that they don’t base that trade on solid market analysis. Neither do they properly consider the risk attached to the trade. Most of the times, this trade is so over-leveraged, that it exposes an enormous portion of the trader’s equity. Now because this trade is often placed impulsively and in a hurry, it is usually a really bad trade. The win ratio of typical revenge trades is really terrible. Consequently, the large majority of traders who get snared in this trading style blow their accounts at some stage. You might get the one or two lucky revenge trades that recover your lost funds, but you will take a knock eventually.
Revenge trades often happen close to the end of a trader’s day. The reason for this is that traders have a certain expectation of how their trading day should turn out, and of course, everyone wants to sit down at the dinner table, satisfied with the decent profit they made for the day. If your wife asks you how your trading was, it’s great to answer: “Honey, I made a really good profit today.” And of course, it feels terrible to say: “I had an awful day in the markets and lost quite a lot of money.”
Pride and certain expectations can be really detrimental to your trading. When you’ve stuck to your trading plan and made some losses in a hard day’s trading, you need to stay cool and wait for the next trading day. Any good trading strategy will lose trades now and then. You need to be mentally tough enough to push through these losses. After all, if you’re risking one or two percent of your equity per trade, you have nothing to worry about if you’re using a strategy which is proven to be profitable over the long-term. Even a couple of consecutive losses shouldn’t shake you at all.
Traders who risk tiny bits of their account on each trade are much less vulnerable to succumb to the revenge trading virus. You see, when you lose a large portion of your equity in one or two trades, it puts you into a situation where your emotions can easily overwhelm you. This is when you start making irrational decisions and lose a grip on yourself AND your trading account. When traders become really emotional, revenge trading can happen almost automatically.
Snare No. 3 – Trading without a Stop Loss
You’ve probably heard this before, but you need to use a stop loss when you trade. I personally know at least two institutional traders who don’t use stop losses, but these guys trade with millions of dollars and use little to no leverage. Even though they don’t use stop losses, they exercise meticulous risk management with each trade they execute. You might be wondering how that’s possible. Well, to use a really simple example, if you open a 1K buy trade on the GBP/USD, the most you can possibly lose is 1000 pounds if the pound loses all of its value, which is of course, highly improbable. The current exchange rate is about 1.2800, which means that 1000 pounds is about $1280 at the moment. If you have a trading account of $128,000, you could trade a 1K lot on the GBP/USD without a stop loss and you’d only be risking 1 percent of your entire account on that trade. This is just a simple, impractical example to prove to you that it is, in fact, possible to trade without a stop loss and still apply excellent risk management.
However, for the average retail trader, it is impractical and very risky to trade without a stop loss. In order for you to abide by proper risk management principles, you need a stop loss to limit your losses according to your predefined risk parameters, for example, risking no more than one percent of your equity on a single trade. Using stop losses gives you excellent control over your trading activities and allows you to use acceptable amounts of leverage effectively.
An important aspect of using a stop loss is that you shouldn’t keep moving it further away from the current market price when a trade goes against you. Inexperienced traders tend to move their stop losses like this and in the end, suffer much greater losses than which was necessary. Moving a stop loss in the wrong direction can be the same as trading without a stop loss at all.
Remember, risk management is probably the single most important aspect of trading. If you don’t get it right, it will greatly limit your chances of success. Don’t use excessive leverage, don’t fall into revenge trading, and remember to always use a stop loss!
Good luck with your trading!