Many traders who have been on the wrong side of a trade have often observed that given a bit more time or more capital, a losing position would have become profitable. Is this the lament of every trader who is wrong? Or is there some hidden truth pointing to time as the critical factor contributing to a losing trade?
There is a natural technical tendency for markets to revert to a mean after prices experience a burst of volatility taking it to extremes. The more time a position is left in the market, the better chance it has for a retracement to take place. Traders using Fibonacci and pivot points are trading these vibrations. The five-minute interval often presents half the range of the 30-minute chart. In contrast, weekly candles can demonstrate 200-pip ranges.
Another factor with direction and timing is that there is often a disconnect between technical price patterns and fundamentals. Fundamentals and technicals are not always in sync because forex knowledge is asymmetrical. This means it is not shared equally among market players. Forex is not an equal playing field where the price efficiently reflects all reasonably known facts about an economy.
While economic forces are the underlying impetus for forex price movements, changes in interest rates, inflation and growth are often inaccurately measured. You have to know what the current inflation rate is and you have to know if you can trust the data. Federal Reserve Board Chairman Ben Bernanke and Jean-Claude Trichet, president of the European Central Bank, are having trouble getting reliable answers. If central bank economists can’t be sure about economic data, how could the at-home traders know more? No wonder forex markets react as if surprised when economic data is released.
Trading intraday and intrahour provides less exposure to market uncertainty but increases risk of losses due to market noise. On the other hand, longer term trades reduce exposure to market noise but increase the probability of wider ranges. Being wrong on an intraday five-minute trade results in a short term loss, while being wrong on a multiday position can result in large drawdowns.
A resolution to this issue is not an “either, or” choice. Instead, forex traders should have two accounts: one for intrahour or intraday trades and one for longer term trades.
For spot trading, longer term forex trades can be shaped off of weekly charts. But launching a long term position strategy for forex should at first be done with the lowest leverage possible. Consider an account with $10,000. A long term trade of $50,000 placed on a currency pair risks $5 per pip. A 100-pip risk through a stop loss would result in a 5% drawdown. Let’s assume that a trader sees five trades that meet that criteria. Being wrong on three of the five trades would result in a loss of 300 pips. At $10 per pip, the losing trades would result in a drawdown of $3,000, or 30%. Assuming the two remaining winning trades reach their targets of 300 pips each, it would generate a $6,000 profit ($3,000 net profit).
The critical factor in position trades is to realize large profit targets. The success in longer-term trades is based on achieving large reward-to-risk ratios. With a 3:1 reward-risk ratio a trader can be wrong seven out of 10 times, with a 100-pip loss, and still be profitable. Trades that offer these large reward and risk positions will be few.
How can these longer term trades be found? The extreme moves of the last year provide unusually large pip targets. For example, the AUD/USD has been at fundamental and technical extremes providing a 700-pip target. The EUD/CAD has moved 2,000 pips (see “What a move!”).
This is not a recipe for everyone, but forex is about the flow of capital in and out of countries and regions. Trading long term positions allows the trader to ride those forces. Traders also can go beyond spot forex for long-term positioning. Futures, exchange-traded currency funds and multicurrency bank accounts are now available to track and profit from currency price movements. With these instrument options, forex is moving out of the domain of the scalpers and into the arena of alternative asset investment baskets.
It is worth serious consideration.
Abe Cofnas is president of learn4x.com LLC and author of Understanding Forex: Trading to Win. E-mail: firstname.lastname@example.org.