Automation, Diversification, and the “Wrong Way” Approach to Forex Trading

trading systems forex trading automation diversification

94% of New Year’s resolutions made fail.  95% of Forex traders lose money. Could there be a connection here?

I believe that the answer is ‘yes’, and can be found in basic human nature.  If 95% of individuals trading in the Forex market lose money, how do the remaining 5% make money?  The answer is simple.  They employ diversification, a consistent trading approach, and proven, successful investment philosophies that overcome the flaws of human nature that lead to loss of principal. What are the elements of human nature that affect success or failure of New Year’s resolutions or Forex trading the most?  Desire, emotion and discipline.

Desire - the motivator that causes a person to take the first step toward achieving a goal.  In the case of the New Year’s resolver, it might be losing weight, ceasing smoking, or making more friends.  For the Forex trader, it’s often the desire for greater income, a retirement nest egg, or peer recognition.  

Emotion – something that often hits the New Year’s resolver early the next day.  Like the person with a hangover who promises the next morning never again to drink, the emotion of last night’s guilt disappears with the New Year’s Day hair of the dog.  Emotion constantly tugs at the Forex trader for attention.   Bits and pieces from cable news stories, advisory websites, and emails all compete for attention with a trader’s chosen system.  Like self pity that sways a dieter watching another person eat that donut, it’s easy to see how a story can make fear or greed part of a trading decision.

Discipline – maybe the worst of all.  The rules of the diet say 1,000 calories per day.  What’s another 10%?  So I set my maximum down to 100 pips.  What’s another 10, 20, or 50? Violating established trading rules and letting losses accumulate in hopes that a price change will make things right, failure to take a reasonable profit, carelessly betting based upon a past ‘pattern,’ leads many Forex traders to the 95% loser door.

Conscious attempts to constantly recognize and avoid the forces of human nature that influence trading decisions aren’t sufficient to minimize Forex risk or maximize trading profits.  The very nature of the Forex trading market creates significant challenges to traders, both new and experienced. Understanding and coping with three fundamental elements of Forex trading present the greatest challenges to the Forex trader: limits versus the amount at risk, market signals and trends, and 24 hour global trading.

Many novice traders who don’t understand the difference in risks involved in Forex versus exchange traded securities find comfort in claims made by many Forex software trading authors who suggest starting with just $500 in a trading account.  Many novices expect that it isn’t a bad deal to risk this little.  But, when the system produces a signal and the trade heads the wrong way, human nature kicks in, and the novice trader becomes nervous on a 50 pip drop.  They might hold, but when they’re wiped out on a second bad decision, the novice is likely to take the loss and move on.  As a rule, a trader should allocate no less than $5,000 to a trading account and then set realistic gain/loss parameters that limit losses to an acceptable degree, but allow gains to run, and avoid the losing process of scalping – taking quick profits.

If profitable trading in a 24-hour global market is difficult for the professional financial trader, it is even worse for the part-time trader.  Professionals are in a position to act when a market signal occurs at 2:30 AM and the part-timer is sleeping.  By the time the part-timer can act, the information is out and the market has already reacted.  Hold-and-hope decisions that violate established goals and trading criteria are one of the prime reasons that 95% of Forex traders lose money.

So, how can one limit risk, set reasonable goals, and apply discipline to their trading while still achieving consistent annual returns north of 30%?

Automated trading, diversification, and a counter-intuitive approach to trend trading strategies used in a number of large trading firms, are gaining traction with the individual investor. 

Automated trading offers some major advantages over manual, signal-based or trend-following trading.  By defining one’s personal trading criteria, the trader eliminates hesitation, spur of the moment decisions, fear, reflection on recent trades, exuberation, and other emotions that cause traders to violate trading principles they have resolved to keep.  When traders set the trading strategy, risk amounts, diversification and buy/sell guidelines, they can comfortably go to work, sleep, play, or go about daily activities knowing that the automated system will buy and sell strictly in accordance with their predefined criteria.  The automated system watches, waits and acts, whatever the hour of the day.  It never sleeps, takes a coffee break, or checks for the trendiest restaurants on an iPad.  Fear, greed, and doubt don’t enter into trading activity.  Automated trading is both the guardian angel and the bodyguard of the investor’s principal.  Scalping, and subsequently regretting lost profits, doesn’t happen.  Holding and hoping for a recovery while losing multiple times the disciplined loss limit doesn’t happen.  Automated trading offers a systematic approach to managing risk, limiting losses, and systematically taking profits.

Automation alone is not enough to minimize risk and achieve consistent profits.

Without diversification, a trader remains exposed to unnecessary risks.  Whereas diversification in stock trading means investing in different market segments, in Forex trading, it is the use of different trading strategies for the same currency pair.  For the scalper, swing, daily, or breakout trader, the manual gymnastics of trading four strategies on one currency pair is beyond most peoples’ capabilities.  Yet some traders are manually trading four or more currency pairs at the same time.  By using multiple automated trading programs, the individual investor can easily implement multiple strategies on the same currency pair or any number of currency pairs. Diversification is not just the number of currencies traded; rather, the optimal approach for trading diversification is the use of multiple trading strategies on the same currency pair.  The power of the computer program to weigh each variable in nanoseconds, recognize an opportunity and quickly trade to take advantage of that opportunity gives the automated trader a major advantage over the manual trader. 

Some try to approximate automated, diversified trading by purchasing two or three low cost, signal-driven, manual trading software systems, assuming that the diversity provided by different vendors’ trading systems will lessen risk and improve trading results.   In actual practice, this strategy usually fails because many of these off-the-shelf software packages are closely correlated in their trading strategies and, therefore, don’t provide the needed diverse approaches to Forex trading. 

Beyond just the adoption of automated trading and trading diversity, there is a counter-intuitive approach that has proven both profitable and risk-minimizing for the individual investor. 

This approach suggests that one observe multiple trading models and resist the temptation to jump on the bandwagon when a model is showing a winning trend.  Clearly, an approach that suggests ignoring a winning system is contrary to what would appear logical.  Why would any sane person want to stay out or go the “wrong way” when they paid good money for a trading system?  Many traders would shudder at the thought of not participating in a clearly winning trend and, if they’re using automated trading, revert to manual, but all investors should know that winning trends end.  They should also understand that losing trends turn around.

Acting at a turnaround is where the greatest profit potential lies.  When the losing ends and the winning starts, they should focus on profits, not the percentage of winning trades. A good trading system can make a killing in the market with 40% winning trades. More profits are made from staying with a single trading system for twelve months, than from jumping around to find today’s best performing system.

What should you take away from successful institutional investors that apply this approach?

Be cautious of winning strategies.  When they are winning, don’t be tempted to jump on board and try to ride the trend.  You’ll probably succumb to human nature and either scalp for a minimal gain, or hang on too long and ride the downward trend.  Instead, sit back and watch the trading strategies that are losing.  Set your trading criteria and wait for the change.  Winning strategies ultimately reach a peak and then decline due to market conditions.  Losing strategies ultimately reach bottom and begin a climb.  When the losing strategies do this, begin trading that model with the idea that you will stay with the strategies and not be tempted to scalp for a short term profit.   If you do scalp, human nature will rise up, you’ll have concerns about re-entering the market, maybe scalp again, and lose out on greater long-term gains.  Counterintuitive?  Yes.  Effective?  Absolutely- I average 35% annual returns using this approach, diversification, and automated trading.  I don’t stress over the market, and I get a good night’s sleep.

100% of Forex traders make decisions.  95% of them are wrong in the long term.  Successful traders inherently know the percentage of successful trades they need to make money.  Successful traders understand how to minimize risk:
1) set trading criteria and stick to it; 2) take advantage of the 24/7 Forex market through automatic trading; 3) apply software systems that allow diversification with at least two trading strategies; and 4) apply a counterintuitive trend-bucking approach and take advantage of long runs.

Winsor Hoang