How to Ruin a Good Trading Model: FX Renew

Last week a trader asked me this question via email:

“I’m worried about the pace of my progress. It has been much slower than expected. So… in 2 years time, will
I be consistently profitable? If not in 2 years, 5 years? 10 years? Before I run out of life? How can I speed up the process? (the process of trading/learning). Since I am not price only based, but sentiment/fundies based, there is a fundamental speed to that, so can’t see how I can speed it up, e.g. going from say 2 trades/ week to 20 trades/week without
completely deviating from the system. Even adding in equities and some commodities won’t materially (order of magnitude) increase the speed. Any ideas?”

This is an excellent question and it’s one of the mental traps that can actually ruin a good trading system. In this article I’m going to offer my view on this because, like many others, I’ve been down the same path before. It’s a tedious matter and here’s why.

Why Trade Frequency Matters

Let’s unravel this trader’s question a bit more. He has recently reached consistency and his equity curve is moving upwards. But apparently he’s only trading twice per week. What he is currently thinking about is the expectancy equation. Let’s briefly recap the basics:  The expectancy formula is:

(Average profit per winning trade)* (% winning trades) – (Average loss per losing trade)*(% losing trades) 

Here’s a realistic expectancy calculation:
($300 x 55%) – ($150 x 45%) = $165 – $67.5= $97.5

The expectancy formula above indicates you had 55% winning trades and each gained $300 on average, with
45% of total trades being losers but at a cost of $150 each on average. Your expectancy for the next trade is a net $97.5.

The good news is that our expectancy is positive, but we also need to take into consideration how much capital we’re using, and over how many trades we can obtain that result.

If you are trading only once per month, in one year you might have a high probability of making 12 x $97.5 = $1170, but if you are doing it on $10,000 starting capital, it doesn’t pass the “So What?” Test which asks “how much money you want to make as a multiple of starting capital?”

Capital Goal = Starting Capital + (Expectancy * Total Number of Trades)

Let’s say you have $10,000 to put into technical trading and you want to make a healthy 25% return this year. Here’s how you rework the equation:

$12500 = 10000 + ($97.5*number of trades)

Even if your expectancy of $97.5 was based on an unreasonable risk per trade, you would still have to make 26 trades per year in order to reach your goal. And this is what is worrying the trader: he feels that, at the current pace, he won’t meet his financial goals fast enough.

Here’s the key: the expectancy equation makes us feel in control of our financial destiny because we can invert the equation and find out exactly what we need to do, in order to reach our goals. However this is a false certainty. All the numbers used in the equation are based on a past performance, exploiting the trading model’s edge. Be very careful: you cannot force anything upon the market, and need to wait for the market to display the right conditions for your model. 

Focus on the process, trade well, and your numbers will look good. Focus on the numbers, trying to push the limits of your model, and your numbers will start to look worse. This is what has happened to another coaching student of mine:

This trader is capable of both great trading (as demonstrated by his ability to pull out of drawdowns just as quickly as he got into them), and poor trading. It’s still the same person, still the same model…so what caused him to get into those nasty drawdowns? The same issue we’re talking about today: inverting the financial goal equation, putting the carriage before the horses.

Focus on the process, and you will perform well and improve. Focus on the money, or on financial goals, and you will trade poorly. I’ve seen this over & over again, so don’t make the same mistake!

Can You Execute Your Current Model Blindfolded?

The number of trades per year is largely dictated by the system you select. I personally feel that this trader is not doing himself enough justice at the moment, because he has in fact been consistently profitable for 8 or 9 months now. The biggest hurdle of his trading career is now behind him.

The trader is a former coaching student of mine, so I know very well the approach he is utilizing is a trend/momentum approach that offers, on average, 3 trades per week. So the fact that the trader is only executing 2 trades per week means that he’s not exploiting the system to it’s limit.  For example, let’s take the pre-identified trades from the morning Cause & FX note, which utilizes the same background/foreground identification criteria.

Volatility has recently been on the rise, so opportunities are slightly more abundant than usual. These are the times to be active with confidence, because there will be other times where traders will need to sit on hands more often than not.

FTSE was pre-identified as early as last Sunday and has taken up the slack this week without too much hassle.

Nasdaq was an additional index opportunity identified intraweek which has also performed admirably.

Crude had been bid up into the OPEC meeting and was also pre-identified last Sunday. This trade would have been, at worst, a scratch.

NzdUsd was on the list as of Monday.

GbpNzd was a potential emerging trade during the week, combining GBP weakness and Nzd strength.

UsdCad was also pre-idenified as early as Sunday. I’ve kept the entry markers on this chart even from last week, to show how it is entirely possible to pyramid into the same trade so long as the market continues to honour the bias. So with this model alone, there were more than a few good opportunities to get into.

So before fretting over trade frequency, honestly answer the following questions:

  • are you identifying all the top-quality opportunities the market is presenting to you each week? So for this model in particular, are you identifying the best existing trends (like the Euro trend that existed prior to last week, and continued through the week) or emerging trends (like the Nzd strength last week or GBP weakness last week)?
  • if your filtering is good, are you getting into the trades via simple triggers? Or are you finding it difficult to execute for some reason?

In other words: where is your confidence dropping? Just like Peter Wadkins covered in our recent workshop webinar, trading is all about confidence. If you’re identifying good background conditions based on your model, but are unable to exploit them, your issue is confidence and the cure is to experiment and test (on a demo account first). Work in a logical, uncomplicated manner and find the solution to your confidence issue.

Quality vs. Quantity

We also need to explore the difference between “being an active trader” and being a “profitable trader”. The trader wrote to me “I’d like to trade more frequently, perhaps 20 times per week as opposed to twice a week”.  Beware of this mental trap: by being more active, you might feel like you’re making progress or “doing hard, valuable work”. However at the end of the day you need to ask yourself these powerful questions:

  • is my increase in activity justified by the end results? (i.e. efficiency)
  • is my increase in time spent in front of the screens at all proportional to the magnitude of my income?  (i.e. opportunity cost)

If there’s no increase in efficiency, then the opportunity cost is likely rising. The extra time you dedicate to trading is not paying off, and you should honestly use that time doing something else. When I had this conversation with an award-winning CTA manager back in the day, he told me to

  • simplify my model to the essence
  • try to get my analysis and trade-related work done in 30 minutes or less, each day
  • go for quality, not quantity

As the graph above suggests, quality is the key to peaceful trading. Quality will keep you out of nasty drawdowns, by keeping your Win% high. Quality will keep you away from overtrading, because you won’t be “looking” for trades, and instead will be “waiting” for trades. Quality will allow you to sit on your hands when the market is simply not ripe for the picking, because you will not be afraid to wait for your edge to appear.

If you really want to be more active, then perhaps diversify with other models. At FXRenew we issue signals for traders with limited time availability  and signals for active traders. And we are also developing other models (Medium-Term and Momentum-Based). Rather than force your will upon the market, getting unreasonably active, why not spread the love and diversify into other models (whether of your own construction or from external sources?).

Don’t Undermine Your Own Progress

Here is a chart from a student of mine that has just finished the coaching process with me. It’s an excellent example of what is possible (over the course of two months) if you focus on the process, filter quality situations, know when to sit on your hands, and cut losses at the knees.

At the end of the day, trading is about making hay consistently. Once you reach consistency, the only think left to do is to grow the account, generate good trading records, and then pass onto bigger & better things like:

  • getting funded (obtain more bang for your buck)
  • opening an autosignals account (generating management fees)

Over to You

You really can undermine your own success, and ruin a viable trading model, if you let yourself get distracted. That’ exactly what was happening to the trader that stimulated today’s article. In his own words:

  • I’m worried about the pace of my progress. (fear of failure)
  • How can I speed up the process? (focusing on the money)

Hopefully now the answers are clear:

  • enhance your confidence with the model by experimenting, testing & receiving feedback from Sam & myself
  • make sure you’re not letting opportunities slip past you (by being consistent in the identification/filtering process)
  • make the best of those opportunities (by triggering trades appropriately, without fear or hesitation and by cutting the losses at the knees)
  • keep filtering quality and disregard quantity of trades or activity
  • maximize efficiency (work smart, not hard)

Don’t ruin a good trading model by succumbing to mental traps. Be disciplined and be scientific with your understanding of the trading model you use. Only by “working with it” can you get to understand it inside out and thus enhance your confidence. And once again, if you’re consistently making hay to any degree, the hardest part of your voyage is behind you.

by | May 27, 2017 – 8.02 am

About the Author

Justin Paolini is a Forex trader and member of the team at  www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.

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