“It does not matter if you win or lose on any given trade, as long as you get the process correct” – Scott Ramsey, Market Wizard

Imagine you owned a casino.

Every day, thousands of bets are made, some of which you will naturally lose.

But at the end of the day, you are always in profit, and sometimes spectacularly so.

This is because you have a built in edge.

Each game that is played by the punter that walks in the door has been carefully designed so that over a long enough timeframe the house will always win.

In today’s lesson we will look at how you can become the “house” when you are trading Forex by developing an edge over the markets.

This requires two things:

  1. An understanding of some basic concepts around probability
  2. Some specific edges that you can choose to have

Let’s start with the true role of entries and exits.

The true role of entries and exits

“Having the faith to stick with the system because I knew that I had the edge was something that helped me a great deal when I went into the pit” – Blair Hull, Market Wizard

To continue with the gambling analogy, each trade is like a draw from a lucky dip or a spin on the wheel of fortune.

The better your entries and exits, the more winners in the draw, and the easier it will be for your trading strategy to meet your objectives.

Your goal for your entries and exits is to add as many winning tickets into the draw as possible – or to add in tickets that when you do pull them, ensure you win the jackpot. This is what the house does at the casino. They stack the draw in their favour, so that over the long term they are guaranteed to win.

When you internalise this concept, you can start to see how entries and exits fit into the bigger picture of your trading strategy. They lose their mystical appeal.

You don’t need to have a strategy that is perfect, just one that produces enough winners over time, with which you can bet enough on each trade to:

  1. Not experience a drawdown over 25% (it’s hard to recover from a drawdown this large without being extra risky);
  2. Achieve your objectives.

Are high probability entries better?

“What really matters is the long-run distribution of outcomes from your trading techniques, systems, and procedures.” – William Eckhart, Market Wizard

Building a trading strategy is a little like building a house. When you construct a house, you decide how many rooms it will have, the layout, how many floors and so on. These decisions are based on your needs (objectives), budget (investing capital) and what suits your personality (psychology).

Similarly, when you develop entry and exit strategies for your Forex trading, you get to choose things like the risk/reward ratio, win rate, and the number of trades over a time period (i.e. you want to place one trade a day). Your choices here will be a reflection of your needs, budget and goals.

Take a look at these three examples of trading strategies.

Strategy 1

Strategy 1 generates 10 trades a month with a 90% win rate. Winning trades make $100 and losing trades lose $1000.

Strategy 2

Strategy 2 generates 80 trades a month with a 60% win rate. Winning trades make $60 and losing trades lose $50.

Strategy 3

Strategy 3 generates 10 trades a month with a 15% win rate. Winning trades make $1800 and losing trades lose $150.

Before you read on, which trading strategy would you prefer?

Note it down along with the reasons why it is your strategy of choice.

Here are the results for a month’s trading for each strategy in dollars:

  • Strategy 1 with a 90% win rate had a $100 loss
  • Strategy 2 with a 60% win rate had a $1280 profit
  • Strategy 3 with a 15% win rate had a $1425 profit.

What do you notice here?

The strategy that made the most profit had the lowest winning rate – and the strategy that lost money had the greatest win rate.

Now, would you still choose the same trading strategy you chose above?

When you are developing your entry and exit, the one with the most wins is not always the best. Be careful not to fall into this trap.

What you are after is the one that give you the biggest edge, or in statistical terms a “positive expectancy”.

What is expectancy?

“The expectancy is really the amount you’ll make on the average per dollar risked. If you have a methodology that makes you 50 cents or better per dollar risked, that’s superb. Most people don’t.” – Van Tharp, Market Wizard

Note that the work below on expectancy and R-multiples is based on the original work of Dr Van K. Tharp.

Expectancy is how much on average you are likely to make or lose when you place a trade in terms of your risk/reward ratio.

For example, if you make on average $1.20 for every dollar you risk, then your expectancy would be 1.2 times your risk. If you make 80 cents for every dollar you risk, then your expectancy would be 0.8 times your risk. If you lose 40 cents for every dollar you risk then your expectancy would be -0.4.

An expectancy above 0 means you have positive outcome.

You calculate your expectancy of your entire trading strategy by averaging the risk/reward over a series of trades, but before we get to the equation it helps to understand what Dr Tharp calls R-multiples.

R-multiples: An introduction to defining your initial risk

“One of the real secrets of trading success is to think in terms of risk-to-reward ratios every time you take a trade” – Van Tharp, Market Wizard

R-multiples are a way of defining the initial risk you take on a trade by thinking in terms of risk/reward.

If you place a trade with a stop-loss 50 pips away from the market, and you are buying a standard lot, then your loss would be (roughly) $500 if the trade went against you. This initial loss of $500 is your 1R risk. The R, of course, stands for risk.

You can then start to express your trades in terms of R, instead of in terms of dollar.

For example, if you place a trade that risks $100 and you make $200, you have made 2R (two times your risk). If you lose the $100 you would have lost 1R.

If you talk to a trader who thinks in terms of R-multiples, they may say:

“I made 2.4R this week”.

Or when they are assessing if they want to get into a position, they may think:

“I have the potential to make 3.6R on this trade”.

How to calculate the expectancy of your trading strategy

Now that you know what an R-multiple is, we can get back to calculating your expectancy.

Add up the total R-value of your Forex trades.

Divide this total by the number of trades you have made.

Here is the formula:

(total R) / (number of trades) = expectancy

For example:

If you had placed 30 trades and earned 45R in the process, your equation would look like this:

45R /30 = 1.5

In this case your system has an expectancy of 1.5.

For further details you can go here.

You don’t need to learn this formula now, just keep it in mind for the future. It’s something we will come back to down the track.

Position sizing rules are developed independent of your entries and exits

Part of the value of thinking about your trades in terms of expectancy is that it separates your success into two distinct components, each of which can be worked on independently.

  1. An entry and exit strategy that generates an average number of R-multiples over time; and
  2. A position-sizing algorithm that is then applied on top of the entry and exit strategy.

The performance of your trading strategy as a whole will depend on the combined performance of each component minus any trading mistakes you make.

To return again to the casino analogy, while a casino has an edge, if they get a high roller in town and they accept a bet that is too big for their bank and lose, then they could get themselves in serious trouble. This would be an example of them making a mistake with their position-sizing model.

Now you know what an edge is, let’s look at some ways to get one.

Ways to get an edge

“One very interesting thing I’ve found is that virtually every successful trader I know ultimately ended up with a trading style suited to his personality” – Randy McKay, Market Wizard

We can’t all buy a casino and rig the odds in our favour, but luckily in the Forex market we don’t have to.

Market behaviour is irrational, so often situations arise where there are opportunities to place trades at prices that provide you with a significant advantage, if you can learn to spot them.

Don’t forget though, that your edge on entry is only part of the equation. How much you actually make at the end of the day will be dictated by your exits and how much you trade (position sizing).

Learning how to trade Forex does not have to be difficult, but you do want to go with something that interests you. Each of these areas will require further research once you identify it to be something you want to pursue. In your compelling model of the market you will have defined some areas of interest already.

Importantly, edges can be combined, and it is often better to have more than one thing going for you when you trade. Just don’t over complicate things.

In lesson #9, Damn Good Set-ups, we go into detail about how to apply each of these edges in your Forex trading plan. For now let’s take a brief overview of each edge.

Global Macro

Global Macro is the big picture of supply and demand factors, and geopolitical events, that impact financial markets. Examples of global macro traders are George Soros, who is famous for “breaking the bank of England” or Market Wizard Louis Bacon whose hedge fund returned an average of 35% a year for investors for more than a decade.

In your compelling model of the market from lesson 4 you will have started to build a framework that includes global macro elements. In the context of edges, you use global macro analysis to place trades in the currency market around these ideas.

You can read more about how to be a global macro Forex trader here.

Global Micro

Global Micro traders look at the news events that are released through-out the trading day and week to uncover trading opportunities. For example you may take note of high impact data releases such as non-farm payroll or central bank rate announcement.

Global micro opportunities can be found by perusing the week ahead data. You can use a tool like Auto-Chartist to view the reaction to previous news events and work out the potential impact for your trades.

Technical Analysis

Technical analysis uses price patterns in the form of bar, candle or line charts to determine future price movements.

The basic premise behind technical analysis is that these patterns represent market psychology, and people tend to do the same thing over and over again, so when you spot one it gives you an insight into what is going to happen next.

In particular, technical analysis can help with:

  • Identifying the market type so you only trade with the trend
  • Finding low-risk high reward entries
  • Buying with momentum
  • Where to place your stop-loss
  • What your profit objective for the trade should be
  • How to manage the position after you have entered

There are probably hundreds of schools of technical analysis that you can learn from. Most are helpful, but not many are good on their own. We will teach you some methods later in the course.

Forex Trading Signals and Ideas

It’s our belief that discretionary Forex trading signals are one of the most powerful methods of trading Forex. You get to keep control of your position sizing and your objectives (which are the things that actually make you money) and you get access to trades that give you a significant edge to your entries and exits.

Importantly, you are alerted to ideas that you might not find yourself, or that confirm your own trades. It’s much better to trade as part of a team rather than on your own.

FX Renews signal providers are current and ex bank and hedge fund traders, and portfolio managers, who have access to sources of information and relationships that a retail trader just does not have. The signal providers all have 20+ years’ track records of successful money management and trading in their own personal accounts.

You can get a free trial of the Forex trading signals here.

Other edges

There are hundreds of potential ways to gain an edge over the market. The one you choose needs to suit you specifically. It’s hard to borrow someone’s edge exactly, though it is easy to borrow one and modify it slightly to suit you.

So keep an open mind and be on the lookout for methods of Forex trading that suit you.

Here are some you can consider:

Correlation studies

It is worth taking note of the correlation between different currency pairs and markets. For example, the moves on gold or the S&P 500 could impact currency pairs and vice versa.

Flow information

Understanding where large orders are sitting in the market and what large orders are in play is a significant edge if you can access this information.

Trend following

“Trend following is an exercise in observing and responding to the ever-present moment of now.” – Ed Seykota

Originally made popular by famous trend followers “the Turtles”* trend followers use often computer driven trading models designed to capture large moves.

*So named after a vat growing turtles in Singapore, the Turtles are group of futures traders hired by Market Wizards Richard Dennis and William Eckhart to solve the question “Are traders born with it, or can trading be taught?”

Counter-trend/ Reversion to the mean

Some traders look for statistical anomalies on the price, such as the price moving several standard deviations from the mean, as opportunities to profit.

Specialization

Some traders choose the path of specialization. They have a particular interest or skill in one currency pair. A trader may choose to be an expert in only the NZD/USD, for example, and get to know everything about that currency pair.

Be careful, your entry and exit are not your only (or most important) source of edges

It’s easy to get sucked in by the mysticism of technical analysis and the likes, and these methods can provide you with a statistical edge (more winning draws).

The “glamorous” nature of entries as perpetuated by Forex educators out to make a buck means traders focus far too much time on when to enter a trade and not enough on other aspects of their trading plan that are of equal, if not greater, importance.

Each lesson that we go through during this course is designed provide you with an advantage. For example, by having clear objectives, and developing a compelling model of the market, you have edges over those that don’t.

Additionally, as a small trader, you have some very clear advantages over your larger institutional brethren.   Let’s take a look at some of these now.

Not having to trade

As a small trader with only yourself to answer to, you are never required to place a trade. On the contrary, institutional traders are often forced to take a position.

In the inter-bank market their job is often to have a position on – they have zero choice. Instead you can wait patiently for the right time to enter and stay out of the market altogether if you don’t know what is going on.  

While institutional traders have a lot more time and resources than you, this edge is very significant.

Being agile with your position-sizing

“Individual investors may feel they are at a disadvantage to large hedge fund managers, but they actually have an important advantage: Their small trading size allows them to move in and out of positions… with virtually no market impact” – Jack Schwager, Author of the Market Wizard books discussing insights from Kevin Daly

As a small trader you can be very flexible in the sizes you trade compared to institutional money. You can place stop-losses and when you wish to close positions you won’t tend to move the market.

Institutional Forex traders don’t have these luxuries; their larger positions can move the market and liquidity can dry up leaving them with worse and worse fills. Often bank traders are forced to work very large positions of hundreds of millions of currency units as they have a corporate order to fill.

Having the freedom to trade any currency you choose

As an individual, you can choose to trade the currency pairs that are going to give you the best chance of achieving your goals. Imagine how big an advantage this gives you over a money manager that can only trade in one currency for example.

Lay down your chips… as the house

“Trading is a matter of probabilities. Any trading strategy, no matter how effective, will be wrong a certain percentage of time. Traders often confuse concepts of winning and losing trades with good and bad trades. A good trade can lose money and a bad trade can win money” – Jack Schwager, Author of the Market Wizards books discussing his learnings from Tom Claugus

It’s time to turn the tables.

Instead of being the chump who comes to the market and is guaranteed to lose, you can start to become the “house” who is guaranteed to win.

Your first step in this process is simply to read about the statistical concepts in this lesson until you feel you have a handle on them. They are an important part of your departure from the trading matrix.

Once you have done that, choose the edges that you would like to focus on developing, such as technical analysis, global macro or global micro.

Note that there are specific lessons later on this course on these topics, but as this is an advanced course it does not cover basics. If these areas are new to you, then you might need to do some beginner courses.

Please, and I can’t stress this enough, don’t get side-tracked by the excitement of market analysis and neglect the other aspects of your trading plan. So many traders (me included once) get enamoured by this aspect of trading and ignore the more important areas such as psychology and position sizing.

Keep working though this course step-by-step, and you will find you allocate the right amount of time to each area.

[bctt tweet=”I’ve been doing the Advanced Forex Course for Smart Traders – http://bit.ly/1NZxrMK” url=no]

Until next time,

Sam,

Sam Transparent Circle

Course work

This week your course work is to practice calculating R-multiples. There are several examples for you to follow in the work-sheet, but the more you practice and get this down pat the better, so don’t limit yourself to the course work only.

When you have (or if you do already) you also want to calculate the expectancy of at least your last thirty trades. You can use this tool to upload your MT4 history and calculate your expectancy if you like, otherwise manually is fine.

You can download the coursework here