Lesson 19: Correct Mindset: Probabilities = Edge

Probabilities lie at the heart of all successful trading. To ensure that we a thinking in probabilities throughout our trading day we concentrate on 3 things.

1. Patience: We understand that the best time to trade is when price is Overbought or Oversold, as these areas represent when a move is near exhaustion and is most likely to reverse. This requires patience, as we must wait for price to become OB or OS to have an edge.

2. Execution: From backtesting our strategy we understand that it’s impossible to predict which trades will be winners. We accept we can't predict the future and focus solely on correct execution to give us our edge. Good entries and exits not only increase our profits, but also limit our losses should our trades go against us (stop loss / trailing stop).

3. Honesty: We understand that in business losing is not always losing and winning is not always winning. This honesty give us an edge by allowing us to avoid trying to fix trades in which there were no errors (ie: losing trade with correct money management, entry and stop placement) or emulating trades in which there were mistakes (ie: winning trade with poor entry, exit and/or money management).   

If we can conduct ourselves with a bias on Patience, Execution and Honesty then we are thinking in probabilities and even losing days are good days because we are trading with an edge.

Lesson 18: Overcoming Cognitive Biases = Backtest

As we trade we will come up against some emotional barriers (biases), they are...
1. Loss Aversion: to have a strong preference for avoiding loss over acquiring gains. When self employed we must be both risk takers and bank managers (risk avoiders), this internal battle represents loss aversion. To overcome it we backtest our strategy to prove to "our" bank manager the business is viable.

2. Outcome Bias: to judge a decision by its outcome, rather than the quality of the decision at the time it was made. This is easy to slip into as we are brought up with a bias on test results (school/work). The problem is tests are based on absolutes and established facts, but business works in probabilities because the factors effecting it continually change. To overcome it we must examine our backtesting to learn its "win/loss ratio" and "max losses in a row". Once we have the facts we know when to ride out a rough patch and when to worry.
3. Recency Bias: to favour recent results/data over older ones.  It occurs after a string of positive or negative results, when instead of accepting the fact that in terms of probability we have just been incredibly fortunate or unfortunate, we start to believe that we are truly gifted or cursed. This bias is a sibling of outcome bias, so is dealt with in the same way.

4. Disposition Bias: to let losses run and take profits early. This is a by-product of greed, fear and inexperience. Greed makes you hope a loser will turn around. While fear makes you quit a winner early, in case your gains reverse. Solution, you've guessed it backtest. Everyone overreacts when they don't have the facts.
Once one's overcome Disposition Bias, problems usually start with Recency Bias (string of losses), leading to Outcome Bias (focusing on results) and finally to Loss Aversion (doubting the strategy). When this happens stop trading and do a day or two of backtesting, this helps tune you back into reality and your strategy.

Lesson 17 Build Self-trust: Back-test and Forward-test, become an expert before you begin.

When backtesting we simply select a timeframe and setup we wish to test (ie on the EURUSD), then review its past chart action to see how it performed. This isn’t a completely fail safe method (as it shows past behaviour, not future) but it gives us a good idea of what we can expect from our strategy. As a general rule I find around 150-200 trades good (approx 8 hours work). We want this large number for 2 reasons. Firstly to filter out any odd results, and secondly to become an expert... We have to place, calculate and record the risk of 200 entries, stop losses and trailing stops (if applic). Trading is not an art, it’s a science. Repetition makes us better. We start on the chart by marking each trade entry and putting 2 numbers by it, 1. The "Risk" in pips (Entry - SL). 2. The "Profit/Loss" in pips (Exit - Entry).

Once we have done this for 200 trades we open a spreadsheet. On the horizontal axis we input, "Date/Trade#", "Risk(pips)", "P/L (pips)"," P/L %" and "Total %". We then input the date and trade number in "Date/Trade#" column, the first number from each trade (on your chart) into the “Risk” column, the second number into the “P/L” column, and then divide “P/L” by “Risk” to get the "P/L%". Finally we add up all the "P/L%s" from the given day (week if swing, month if position) and place that number in our “Total %” column.

This gives us ample data to help create an income (ie Net P/L, win/loss %, biggest win, average win, average loss etc). We don’t cut corners, it’s the repetition that makes us experts, gives us reliable data and creates self trust!

Finally forward testing requires us to trade the strategy in real time using either a demo or micro account (we're not fully invested!). This allows us to practice and learn how to implement it in reality while fixing errors that a moving market with slippage will create, believe me there will be errors! Once we have tripled our demo account we can fully invest.

Lesson 16: Match Yourself to the Market

We must remember that we are traders, not investors. We covered Fundamental Analysis first (how to value currencies) because doing so makes the currency market transparent and unthreatening. But we (traders) understand that most of the time the market is ruled by emotion, (why else would prices fluctuate when there has been no change in valuation) So we trade emotions most of the time and changes in valuation as and when they occur. To increase our chances of success we trade the most liquid pairs, EURUSD, USDJPY, GBPUSD, USDCHF, AUDUSD, EURJPY. All traders are looking for the same thing, overbought and oversold areas. So the more traded a pair is, the more likely these areas (OB/OS) are to work. EURUSD is the most liquid of all pairs and is where we should start.  A lot of people assume that one can only trade if they give up their day job, this is a complete misnomer. Only day traders need to monitor the market constantly throughout the day. The key thing is to find the smallest timeframe you can trade comfortably because the shorter the timeframe, the more setups you get and thus more profit you will make. But you need to remember that every time a session closes you will need to take a look at the chart, a 1 hour chart means we need to look at the end of each every hour (because we use the close as our signal). We have a few options. 1. trading off the weekly or daily charts means we never have to look at the market during the day, but reduces our returns. 2. venture into the hourly charts, H1 requires looking 8 times at work, H4 only twice. OR 3. Daytrade the AM (6am-8am) or PM (5pm-7pm) sessions before/after work. We should play around for a little while but ultimately we want to decide on one pair, one timeframe and one setup because we need to become experts. If we keep changing the parameters we will quite literally become Jacks of all trades, masters of none.

Lesson 12: Basic Technical Analysis, Reading a Chart

We read a price chart from left to right.  There are 2 axis, Price (vertical) and Time (horizontal). The most basic form is a line chart, it is made by joining the closing price of each day/session to form a constant line. Below is an example of the daily EURUSD.

Price can only go in three directions, up (uptrend), down (downtrend), and sideways (range/chop). An uptrend is defined by a series of higher lows and higher highs, a downtrend by a series of lower highs and lower lows and a range by a series of highs and lows that stay within a range.

The next example is of a bar chart. As you can see it has a similar shape to the line chart, but one can now see the additional data the line graph had to miss out to draw a straight line.

On a bar chart each day/session has it's own individual bar. The horizontal line on the left is the open (O), the high of the vertical line is the high (H), the low of the vertical line is the low (L),  and the horizontal line on the right is the close (C).  So we call bar charts OHLC.

The following is a diagram of the same sessions as Japanese candlesticks. As you can see they are much easier to read because they are colour coded, white = up (bullish/optimistic), black = down (bearish/pessimistic). The rectangle is called the real body and the vertical lines are called shadows (upper and lower).

When viewing bars and candles the open gives you a reference, the highs represent the markets hopes, the lows its fears and the close what it truly believes.

Look at the candles above. We can see that although the first candle is technically “bullish” (because it closed higher), it is actually quite pessimistic as it tried hard to make new highs but lost it’s confidence, closing near its low. This is also true with the “bearish” candle which is actually quite optimistic, as it closed nearer it’s high.

Below is our chart of the EURUSD in candle format (green = up, black  = down).

Lesson 11: Introduction to Technical Analysis (Price Charts)

Technical Analysis is the study of price action (charts). It has been used in the west for approximately 100 years, while in Japan it has been in use for over 300. Price action it is said to depict the battle between the Bulls and Bears. The Bulls pushing the market up with their horns, the Bears pulling the market down with their paws. When looked at over a period of time one can identify if investors have been buying or selling an instrument (trend), price levels where investor confidence has waned (supply/demand) and areas to buy or sell (Entries/Exits). These are our 3 Technical Analysis objectives. 1. Identifying Direction (trend). 2. Identifying Overbought/sold areas (suppy&demand). 3. Identifying Entries/Exits. This in essence, is all trading is! If you get the direction wrong, are not aware of potentially weak areas in price and don't know when to buy or sell, you're going to lose money! NB although It’s important to understand the concepts of bullish and bearish I prefer not to view the marketplace as a battle ground. The market is one entity not some schizophrenic beast, to me the market is human (as it’s made up of humans) and price action represents its/our overriding emotion. Be it optimism (up), indecision (choppy) or pessimism (down).

Lesson 10: Trade and Money Management Strategy

Recap of the prior 4 lessons... Currencies are abbreviated to a 3 letter code and then put into pairs. When viewing a quote ie “EURUSD 1.30025 - 1.30027” the EUR is the 1st currency, the USD is the 2nd currency, the first number is the “bid/sell” price,  the second number is the “ask/buy” price.  The difference between the bid and ask is called the spread. If you bought the EURUSD you would be buying EUR and selling USD. if you sold the EURUSD you would be buying USD and selling EUR. There are 4 FX markets. 1. Spot in which you actually purchase currency, 2&3. Futures and Options in which don’t actually buy the currency but a contract instead.  and 4. Spread Betting where you can trade just like Spot, Futures or Options, but bet instead. Placing a trade... To buy hit the “ask/buy” button on your platform, to sell you hit “bid/sell”. Bet Size means how much do you want to bet per point (a 10 pip move at £2 per point = £20). Stop Loss and Take Profit orders do exactly what they say. Generally you want a RRR of 1:2 or greater, so your TP should be twice the size of your SL. You can move you SL in a trade, this is called a trailing stop (ensure you track loosely to ensure you’re not stopped out early). Managing Money... Divide your capital into 100 even lots, to ensure your maximum loss on any one trade will only be 1% of your account. In each trade our risk is the point difference between our Entry and Stop prices, we call this the “Stop Size”. To ensure that our Stop Size (entry price - stop price) does not exceed our max risk per trade (1% of our capital), we need to divide max risk per trade (1% of our capital) by our Stop Size (Entry - Stop price), this gives us a bet size that will not exceed our max risk per trade.