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Today we feature a guest post courtesy of TrendTradingDNA, a financial web service that offers members technical analysis, trade alerts and education for trading Forex, Commodities, Stocks and Indices.
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A common mistake among traders, no matter of experience of knowledge, is over sizing of the trades.
How can you reduce the fear from entering a trade?
When there is a good set up, the most of the traders make a common mistake, they take a large size trade, thinking that the market will reward them and attaching the larger probability of successful trade then it is. There is no 100% probability in the market even if it is a technically perfect, school example pattern. There is always a chance that the trade will be stopped out. Thinking that large trading size will give more profit to traders is wrong, because in the case of the stop loss hit their equity will be reduced and the pattern will work without them in it.
We will try to illustrate this with USD/JPY example. In USD/JPY we have identified medium-term uptrend as it can be seen on the chart.
Also from the chart, we can see that the pullback is in progress. Now we have only a question where this pullback will end. Looking at the early signs of reversal we could assume that the moment of pull back end is near, and we have descending wedge pattern (usually bullish). So how can we trade this?
There are a lot of traders that will use, at this second bounce from the 113.700, the max size. For this example let say this would be 0.50 mini lots (50.000 unit). Let us do the calculation.
- Going long from 114.100 with 113.550 stop loss and 116 target will give us possible 240$ loss and 818$ profit. Tempting. But what if the market wipes out stop losses below 113.700 and sharply reverses higher like it usually does, you will loose 240$ and possibly not enter another long trade because you lost the momentum.
Let us now see a smaller size, used for the trade, 0.05 micro lots (5.000 units)
- Going long from 114.100 with 113.550 stop loss and 116 target will give us possible 24$ loss and 81$ profit. Easy to enter a position now. It is not a big loss in the case of stop losses wipe out below 113.700 and sharp reversal. If you got stopped out and in the end of the day USD/JPY closes higher, 114.500 for example, and you expect a continuation to 116 and possible extension to 120, you can enter a new long with 0.005 size and place a stop loss at 113.700, risking new 35$. And if USD/JPY break 116 the wedge and continue higher, you will move your stop loss to breakeven entry 114.500 and place a new trade at 116 with the stop loss at 114.500 risking new 65$ on the second long entry. And you have now a target for new trades at 120 with the combined profit of 395$ at the target and combined loss of 124$.
The combined loss at 0.005 lot size is 50% of the possible loss on just one trade with 0.50 lot size and you have increased the probability of a trade success because you have three entries instead of one. The importance of enough equity for more entries in the forex market is priceless.
Looking at this example above now when you see a great pattern, you will have more confidence for entering a trade, with the smaller size than with larger size. With larger size you possibly have just one chance which reduces the probability of successful trade, no matter the size of your equity
Even if you have the series of good gains in the market, it is always better to trade with the same size and not increasing it, because you can build the position with many small lots and make a portfolio of trades which will give combined profit. With the large size you are giving yourself much less probability and trading the market is all about probabilities and not the certainty.