The foreign exchange market (forex) has a low barrier to entry, which makes it one of the world's most accessible day trading markets. If you have a computer, an internet connection, and a few hundred dollars, you should be able to start day trading.
This easy-entry is not a promise of a quick profit, however. Before you take the plunge, consider these 10 common mistakes you should avoid, as they are the main reasons new forex day traders fail.
If You Keep Losing, Don't Keep Trading
There are two trading statistics to keep a close eye on: Your win-rate and risk-reward ratio.
Your win-rate is how many trades you win, expressed as a percentage. For example, if you win 60 trades out of 100, your win-rate is 60%. A day trader should work to maintain a win-rate above 50%.
Your reward-risk ratio is how much you win relative to how much you lose on an average trade. If your average losing trades are $50 and your winning trades are $75, your reward-risk ratio is $75/$50=1.5. A ratio of 1 indicates you're losing as much as you're winning.
Day traders should keep their reward-risk above 1, and ideally above 1.25. You can still be profitable if your win-rate is a bit lower and your reward-risk is a bit higher, or vice versa. Try to keep it simple though, and develop strategies that win more than 50% of the time and offer a better than 1.25 reward-risk ratio.
Trading Without a Stop Loss
You should have a stop-loss order for every forex day trade you make. A stop-loss is an offsetting order that gets you out of a trade if the price moves against you by an amount you specify.
When you have a stop-loss order on your trades, you have taken a large portion of the risk out that investment. If you start taking losses on a trade, the stop-loss prevents you from losing more than you can handle.
Adding to a Losing Day Trade
Averaging down is adding to your position (the price you purchased the trade at) as the price moves against you, in the mistaken belief that the trend will reverse. Adding to a losing trade is a dangerous practice. The price can move against you for much longer than you expect, as your loss gets exponentially larger.
Instead, take a trade with the proper position size and set a stop-loss on the trade. If the price hits the stop-loss the trade will be closed at a smaller loss than it would have without it. There is no reason to risk more than that.
Risking More Than You Can Afford to Lose
The key part of your risk management strategy is to establish how much of your capital you are willing to risk on each trade. Day traders ideally should risk less than 1% of their capital on any single trade. That means that a stop-loss order closes out a trade if it results in no more than a 1% loss of trading capital.
That means that even if you lose multiple trades in a row only a small amount of your capital will be lost. At the same time, if you make more than 1% on each winning trade your losses are recouped.
Another aspect of risk management is controlling daily losses. Even risking only 1% per trade, you could lose a substantial amount of your capital in a single bad day.
You should set a percentage for the amount you are willing to lose in a day. If you can afford a 3% loss in a day, you should discipline yourself to stop at that point. Day trading can become an addiction if you let it. Only play with the money you have set aside, and stick to your strategy.
Going All In (Trying to Win It All Back)
Even if you have a risk management strategy in place, there will be times you will be tempted to ignore it and take a much larger trade than you normally do. The reasons vary, and you'll be tempting fate to do her worst.
You might have had several losing trades in a row, which will make you want to earn back some of the losses. A winning streak can make you feel as if you can't lose. There will always be one trade promising such good returns, you are willing to risk almost everything on it.
If you risk too much you are making a mistake, and mistakes tend to compound. Traders have been known to their stop-loss order in the hopes of a turnaround. Many also get caught up keeping their margin, telling themselves it will turn around and they'll win big.
When you feel this way, stick to your 1% risk per trade rule and your 3% risk per day rule. Resist temptation, stick to your risk management strategy and avoid going all in or adding to your position.
Trying to Anticipate the News
Many pairs (two stocks—one long, one short, both correlated) rise or fall sharply in the wake of scheduled economic news releases. Anticipating the direction the pair will move, and taking a position before the news comes out, seems like an easy way to make a windfall profit. It isn't.
Often the price will move in both directions, sharply and quickly, before picking a sustained direction. That means you are just as likely to be in a big losing trade within seconds of the news release as you are to be in a winning trade.
There is another problem. In the initial moments after the release, the spread between the bid and ask price (highest purchase price and lowest sell price) is often much bigger than usual. You may not be able to find the liquidity you need to get out of your position at the price you want (using smaller trades to get out of the position).
Instead of anticipating the direction that news will take the market, have a strategy that gets you into a trade after the news release. You can profit from the volatility without all the unknown risks. The non-farm payrolls forex strategy is an example of this approach.
Choose the Wrong Broker
Depositing money with a forex broker is the biggest trade you will make. If it is poorly managed, in financial trouble, or an outright trading scam, you could lose all your money.
Take time in choosing a broker. There is a five-step process you should go through when deciding on which broker to use. You should consider what you want to accomplish, what a broker offers, and use reliable sources for broker referrals. Then, test the broker using small trades at first, and don't accept offers of bonuses with their services.
Take Multiple Trades That Are Correlated
You may have heard that diversification is good. Diversification is a strategy that depends on your knowledge, experience, and what you are trading. Warren Buffett once said about diversification:
"Diversification is protection against ignorance. It makes little sense if you know what you are doing."
If you believe in diversification you may be inclined to take multiple day trades at the same time instead of just one, thinking you are spreading your risk. Chances are you are actually increasing it.
If you see a similar trade setup in multiple forex pairs, there is a good chance those pairs are correlated. That is why you are seeing the same setup in each one. When pairs are correlated, they move together, which means you will probably win or lose on all those trades. If you lose, you have multiplied your loss by the number of trades you made.
If you take multiple day trades at the same time, make sure they move independently of each other.
Trade Based on Fundamental or Economic Data
It is easy to get caught up in the news of the day or to form a bias based on an article you read that says economic conditions are good or bad for a particular country or currency.
The long-term fundamental outlook is irrelevant when you are day trading. Your only goal is to implement your strategy, no matter which direction it tells you to trade. Bad investments can go up temporarily, and good investments can go down in the short-term.
Fundamentals have absolutely nothing to do with short-term price movements—using fundamental analysis causes you to focus on the wrong concepts and form biases. Any long-term biases can only cause you to deviate from your trading plan. Your trading plan and the strategies it contains are your guide in the market and prevent you from taking unnecessary risks, or gambling.
Trading Without a Plan
A trading plan is a written document that outlines your strategy. It defines how, what, and when you will day trade. Your plan should include what markets you will trade, at what time and what time frame you will use for analyzing and making trades.
Your plan should outline your risk management rules and should outline exactly how you will enter and exit trades for both winning and losing trades.
If you don't have a trading plan, you are taking unnecessary gambles. Create a trading plan and test it for profitability in a demo account or simulator before trying it with real money.
If these tips seem similar to warnings about gambling, it is because they are. Day trading, or stock trading in general, can cause people to win and lose a fortune in a day—recent studies and theories behind compulsive trading addiction are gaining strength (for valid reasons), and you should be on the lookout for the signs.
Planning and executing anything takes patience, skill, and discipline. As you get deeper into day trading, you should step back and adjust your plan as time goes on. As your financial and personal situations change, you'll find it beneficial to implement different strategies at different times. However, these 10 precautionary measures should guide you through your evolving skills and plans.