Differentiate Between A Losing Trading Strategy And Poor Psychology
Markets are very dynamic, as we all know. Traders starting their trading journey, and even trading veterans, can find it difficult to determine whether a strategy is to blame for poor performance or if the individual is unintentionally sabotaging their trading results.
Finding a profitable Forex trading strategy can be hard enough as it is, but how can we differentiate between whether issues are based on our trading approach or if the fault is in our psychology? Thankfully, there are answers to this question…
Testing and expectancy are the answers to every Forex traders’ prayers. Once we have these objective pieces of information, the root problems can be found and crucial decisions can be made. But what do testing and expectancy mean?
Testing, also referred to as backtesting, involves executing a trading strategy using historical prices and data of a given market. Since the prices used are based on the actual trading that took place at the time in that market, the historical performance of an approach/ strategy can be used to gauge possible future performance.
Backtesting would easily make it into my list of “Forex trading commandments” and with modern technology, this task is easily carried out using computer software.
Expectancy in trading means will you make money or not over a large sample size of trades. There are many methods and calculations to determine expectancy but the simple components are win % and risk to reward ratio. By combining these values we get an idea of the expectancy of a strategy.
Win % tells us how often a strategy is supposed to win e.g. 45%. While risk to reward ratio shows the average losing trade (in $) vs the average winning trade (in $) e.g. if the average winning trade is $3 and the average loser is $1, then the ratio would be 3:1.
You may be thinking I am losing the plot, this article is about differentiating between issues in our trading psychology vs in our strategy, but now everything will come together. Here are the steps you should go through:
1. Backtest the strategy on the markets that you are currently trading.
2. After you have a sufficient amount of trades from the backtests to make sure the results are valid (at least more than 25 trades but 100+ Is best) move onto the next step.
3. Calculate the expectancy of the system by using the win % and risk to reward ratio from the backtest trades. In this way, the backtestng has allowed us to determine the expectancy of the strategy.
4. Now you can predict with a good amount of certainty whether or not the strategy will make you money i.e. whether or not it has a positive expectancy.
Is the problem trading psychology or the trading system?
Now we can address our issue. Is the problem psychological or is it in the system? The numbers have spoken and as Forex traders, our job is to listen…
If the system has a negative expectancy and you have been getting negative results then the problem is the approach, not you. It does not matter if you have the best trading psychology in the world; great psychology cannot fix a broken system. The best plan of action, in this case, is to adjust your approach or try out a new system entirely.
If the system shows a positive expectancy but you have been getting negative results over a large number of trades, then the problem is likely your trading psychology. But that is fine, there are plenty of ways to fix that and improve. The best plan of action in this situation is to read books/ articles on trading psychology and to simply gain more experience in the Forex markets. The more time you spend trading, the better you will be able to master the emotions of this demanding industry.
Should you find yourself in the hole of determining why results are short of your expectations, this is a great process to come to a conclusion and find the best way forward for your trading.
Never stop working, never stop testing
Trading strategy vs. execution FAQ
Backtest your strategy over a large sample size to determine if it makes money or not. Depending on the results, you may have to analyze the data to improve the strategy or try a new one.
If you follow your trading strategy and risk parameters, you are not to blame for losses. Look deeper at your system and determine if it has an edge or if current market conditions do not favor your methodology.