My Mistakes and Building A Trading Strategy (part 2)

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February 20, 2012 9:46 AM EST

FXEmpire

I am going to share a personal story with you about my beginning in the Forex markets and how I learned how to develop a trading strategy and the mistakes I learned along the way. I share my journey with you in 5 articles, as you will see that I have developed very good trading strategy overtime. I hope you can learn by mistakes and that you use my system as a guide or comparison to your own. If you like please comment and share your experiences and thoughts.

This is the second part of my story and my mistakes. Please follow me the rest of the week and share your comments. I have already heard from readers who have read PART 1 so continue along with me.

When we left off, I was talking about alternatives to the original steps I had taken to develop a trading system.

6. Systems

During all this time, you will have probably tried 3, 4, or more, methods/systems. Blogs and articles devoted to them are endless.

However, let's assume you've found one that you think suits you. You've sorted out all the points raised above. You've made money on a demo account, or shown steady growth using micro lots. At last, you think, I have this trading thing cracked. Now you're thinking about the house on the beach again. 

Stop. 

This is the one time when you need to sit back and take the time to ensure that the move to a live account, or time to up the ante, is sensible. Depending on how much time has passed, you may not have discovered yet that all the weaknesses have been revealed. Your weaknesses, or the system's. 

If you've been trading an MA crossover method during a great trending period, you're unaware of all the bear-traps hiding ahead of you when things move into range-trading mode. All of a sudden, things are going wrong. Instead of lots of winning trades, you're getting more losers than you'd come to expect. What happens to most of us is we immediately head off into The Indicator Trap. Stops are important but so is risk management, but you can continue to get stopped out of a good trade and end up making the right trade with the wrong stops and find out at the end of the day that you lost over and over again.

7. Indicators

As a newbie, I believed that all I had to do was to learn to recognise the RIGHT signal, at the RIGHT time. Not only that, but if I could get 3 or 4 of these indicators' signals ALL lining up at the RIGHT time, I would have cracked it. It seemed so easy. I'd stay out of red news days, not trade Mondays or Fridays, and wait until the London Session opened. I studied all the Trading Systems, trying this one, trying that one, never quite getting to grips with any of them. Maybe if I'd stuck with one I might have done better, but I just couldn't find a method that suited me. Obviously the guys that designed them knew how they worked, but after a while I got tired of endless posts trying to modify the methods, or adding another indicator. All in an effort to prevent losing trades. I now know that this is not possible.

Why do I call it the Indicator Trap? Simple really. Indicators, for most newbies, are a crutch that you end up thinking you need to make a trading decision. The rules for entry can be so complex that you spend your time watching the indicators, and forget about watching the markets, as reflected in your charts. I also believe, rightly or wrongly, that they were designed to work in a completely different market place - not forex. Having had an interest in stocks and shares in a previous life, I understood that decisions on buying, or selling, shares were premised on something different to FX. There is a longer-term view taken when considering buying shares, because apart from capital growth in the shares themselves, there was the additional benefit of dividend income. Buy and hold is not an attitude you meet very often in your early introduction to currency trading, and certainly has no relevance to a 5-min chart on EUR/USD, not in my mind anyway.

So there we all are, applying Slow Stochastics to fast moving forex charts, where, on any given day, a currency pair can move 100 pips or more. No wonder some of these indicators are always behind the action. The next thing we do is alter the settings, taking them down to even shorter timescales, expecting them to still perform the way the author designed, and optimised, them to work. I've had Stochs down to 5,5,3 just because it seemed to match what I wanted to see on the chart. If I still couldn't make the right call, I'd apply RSI, and adjust its settings until it seemed to match what I needed to see, or maybe CCI, or ADX, something, anything that would give me that magic signal.

Even the simplest indicator, the Moving Average (MA), is not the answer. Not in the way we think it is when we first apply it to a chart. I've tried all combinations of MA cross systems, and all have a weakness that I couldn't quite come to terms with. I didn't know why at the time, even though I knew I was dealing with something that dealt in averages. 

The warning bells still weren't ringing. The answer is that these MAs lag. Obvious now, but, believe it or not, that simple fact didn't register. Too often, by the time I'd hit the order button, price was on a different path, adding a new position to its sequence of averages, and generally that path was against my trade.

I would love to tell you newcomers to clear all the indicators off your screens, but I know it would be a waste of time. Like any addiction, (I speak as a smoker) old habits die hard. At this stage we don't understand the markets well enough to simply trade the charts without some help. Even I have a couple of EMAs (Exponential Moving Average) on my screen, but I use them differently to how I did when I started. How I use them I will explain in due course, but I am starting to see that I really could get by without them.

So, this is the first message. Start clearing your screens - watch price and then check if Stochs, RSI etc are confirming. Remember that you should be using these tools as Points of Interest, areas where a trading decision could be made. Learn to read your charts and don't just blindly follow what you think may be a signal. Try and learn the patterns that occur around these Points of Interest. For example, if you trade a MA cross method, does price ever pullback to the faster MA before taking off again? Maybe if you seem to get into a trade a bit late, and your stops are getting taken out too early, then why not wait for a pullback, if that pattern happens often enough, and go in as price bounces off the MA.

Indicators, of themselves, aren't bad things. The problem is we, in our development stage, don't understand how they work. Nor do we apply them to our trading in a logical way.

A classic here are the Overbought/Oversold signals give by certain indicators. Have a really good look, and see how long, and how often, Stochastics have been screaming Overbought on GBP/USD. I've been in most of this uptrend, on and off, for weeks, and I've always been Long.

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