There is an often-mentioned grim statistic out there that 95% of all traders, including all forex traders, lose.
What are the sources of this grim statistic? There is a writer named marketstudent who briefly explores any evidence to support or disprove the claim that 95% of all traders lose in a nicely researched article called Do 95% of all traders lose?
We describe common causes of failure in the points below:
- Odds are Against you Due to Transaction Costs
- Competition is Vastly Superior and More Sophisticated
- False Expectations (Instant Success, Incredible Returns, Holy Grail)
- Over trading
- Lack of Knowledge
- Lack of Experience
- Emotion (Greed, Fear, Ego etc.)
- No Trading Plan or System
- Unsustainable or Flawed Money Management.
1. Odds are Stacked Against you Due to Transaction Costs
At the onset of every trade, you are in the hole due to the spread or commission, and you have to work hard to get yourself to break-even or profit. The retail trader always pays the Bid/ask spread, which makes his odds of winning considerably less than that of a “fair game” and he may incur additional charges from commission (with some ECN brokers) or the overnight interest of keeping his position open for more than one day. This trading cost makes the odds of winning considerably less than 50%, or flipping a coin. It should be noted that brokers and banks generally grant considerably tighter spreads to the larger clients, which gives them a cost advantage we do not have.
Moreover, in forex day trading, because forex vacillates up and down, you have to be more or less correct on the entry and the exit, which is tantamount to having to guess right twice in a row if comparing the odds to a coin toss. Luck will not win in forex.
2. Competition is Vastly Superior and More Sophisticated
In our article on Who Trades Forex, we illustrated how we the retail traders still only comprise 2% of the whole FX market volume, and being the lowest on the food chain in terms of size and sophistication, we are the most readily eaten up. The larger traders (the banks, corporations and hedge funds) are the sharks in these waters, trading day and night, knowing the ins and outs of the market, and they eat the weak. They employ sophisticated trading systems that sniff out the unsophisticated traders who are more likely to put stop orders at obvious levels of support and resistance. Some brokers publish their in-house ratios of longs to shorts on any given currency on any given time, called sentiment, and since they know that most retail traders lose, the recommendation is to trade counter to the retail sentiment or directional bias.
In the big picture, then, the retail forex trader is not pitting his wits against other retail traders that only comprise 2% of the liquidity. Instead, he is pitting his wits against the institutional traders working for the banks and hedge funds that comprise 90% of the liquidity. In such a situation, the playing field is not fair. The typical retail trader has limited trading capital, is often inexperienced, trades with free online tools, and can only spend a fraction of his time trading the market. The typical institutional trader, in contrast, is well capitalized, has considerable experience, more sophisticated trading tools, and can devote most of his day to trading the market. Having more capital, more sophisticated trading tools, more experience and education, and more focused trading time, the institutional traders are like the sharks in the fish tank preying on the weaker and smaller retail traders whose accounts are swallowed up by their own trading mistakes.
3. False Expectations
False expectations can be broken down to: looking to get rich quick, achieve incredible monthly returns, and rely on the “holy grail” system to get you there.
Looking to Achieve Instant Success
Forex has gained a reputation as the ultimate “Get Rich Quick” scheme. This hype is perpetrated by numerous entities (system vendors, signal providers, seminar or chat room gurus, even forex dealers and brokers) all trying to make money out of naivety and greed. They all propagate the idea that one can get extremely rich trading forex, that you can retire wealthy within a short period of time, or that you can quit your job to trade forex for a living.
Looking to Achieve Incredible Returns
If you are a new trader expecting to make 20-100% of your initial trading account per month, you have already an improbable goal that is detached from reality and unworkable. The only way to make such huge profits is to use high leverage or trade multiple times per day, both approaches of which may work for you for a short while but will eventually destroy your account. You will enter into the double dangers of over-leverage and over-trading, as discussed below.
There was once a gentleman on a plane who said that he was going to make a living from being a forex trader on an account of $6000. He was simply naive. To survive in this world a person generally needs to make 2K per month, more if raising a family, and that bread and butter money is best earned from a job or business. To think that you can make 2K per month from your initial $6000 is to think that you can consistently earn 30% per month, which is improbable. Forex is just too dangerous an arena, and to try to accelerate your trading (over-leveraging and over-trading) to achieve a 30% per monthly return so that you can pay your bills is a quick recipe for disaster.
Looking for the Holy Grail
Most people new and old to forex are looking for the best trading system around. You can sympathize with the quest for the Holy Grail. There have been many seekers and to some degree there still are. You can hold a long optimistic that somewhere out “there” someone has built the system that can beat the system. There is a lot of crap out there, but if you can search far enough or dig deep enough on the net, you can find that “holy grail” system that others could not find and use it to build your fortune.
The problem is that 95% of systems are unprofitable for numerous reasons, and the great system of today can be in the waste bin tomorrow. Markets change and the system making a steady profit in the last six months can suddenly find itself in a heavy, unexpected drawdown. This happens with the best of scalping systems. Many of the best had made great returns during the Asian session for two straight years, returns consistent with their 10 year back tests, and then in 2011, you could see them blow up. The historically range-bound period of the Asian session suddenly became a trending session and the counter-trend scalping trades initiated by the scalping EAs backfired on the accounts.
A foremost reason for why many forex traders fail is that they are over-leveraged in their trades. Or put another way, they are under-capitalized in relation to the size of the trades they make. With the false expectation that they can make 20-100% monthly returns, the new trader maxes out on the available leverage, quickly blowing up his account. The forex market allows traders to leverage their accounts as much as 400:1, which if fully used can lead to massive trading gains in some few cases, and crippling losses in most others.
Even with the more common 100:1 leverage offered by most forex brokers, if the trader were to fully use the 100:1 leverage offered, his entire account can be wiped out in one trade. If the trader had a mini account of $1000, for instance, and used the 100:1 leverage to buy 1 standard ($100,000) lot, the currency pair would only have to travel against him by 100 pips before he was totally wiped out (100 pips X $10 per pip=$1000). The trader was trying to carry too big a position with too little money.
It is interesting that US regulators recently took the extra step to limit the leverage of US brokerage firms to 50:1. They did so with the stated objective of trying to protect the retail investor from hurting himself. But limiting the capacity of leverage will not protect a US client from abusing leverage and destroying his account. A greedy US client can still blow up his account if he were to use the full 50:1 leverage offered: the only difference being that he can only control half the lot size as he did under the 100:1 leverage, and thus it will take him 2 bad trades of -100 pips instead of 1 bad trade of -100 pips to completely wipe out his account.
The new forex trader thinks that if he can couple the use of high leverage with frequent trading, he can make huge profits. What he does not notice is that the forex market is volatile and changes direction all day long, and it is impossible to expect profitable trades from every price movement. There is a reason why researchers have noticed that up to 90% of day traders fail: the day traders are exposing their accounts to more risk and reducing their win loss ratio. They are taking too many trades of short duration, trying to trade each change of direction on a small time frame scale, and often get chopped up in the process. They are also increasing their cost of trading as each time they trade they are paying the spread or commission.
There are various reasons that forex traders over-trade, such as excitement of trading, revenge trading to make up for past losses, missing a forex trade and then chasing the market, etc. Ultimately, overtrading is the result of having no discipline, no plan and no patience.
6. Lack of Knowledge.
One of the reasons forex traders fail is because they don’t have enough education. They come into trading without even opening a forex book or educating themselves about currency trading. Some forex traders barely understand what technical and fundamental analysis is, and they execute trades on whim, intuition, gut instinct, the market moving sharply in one direction or the news of the day suggesting the direction in hindsight. Consequently, without knowledge of how/why prices move, many traders fail.
7. Lack of Experience
Often new traders become so fascinated by an indicator or system that they dive right into real trading with it in the hopes of getting rich quicker. The allure of quick profits prevents them from waiting patiently and practicing first with demo accounts and micro accounts. Or perhaps they already practiced with a demo account for a couple months, made some decent trades, and have convinced themselves that they or their system is capable of beating the market. Then they try their hand at a real account and discover that greed and fear interfere with their trading and that the market of tomorrow bears little resemblance to the market of the last few months.
Their lack of experience as traders makes them undisciplined, impatient and emotional, causing numerous trading mistakes. Their lack of experience with the multiplicity of forces affecting the markets, as well as its high degree of randomness, causes them to underestimate and overestimate the market, causing numerous false interpretations of market direction. Their lack of experience with money management causes them to risk too much on each mistaken trade and they eventually get wiped out.
Human traders have a number of weaknesses, the foremost being Greed, Fear, Ego, Addiction, and Laziness.
Greed: One of the seven deadly sins, it is the main cause why traders lose in forex. Because of our short lifespan and eagerness to make money fast, greed leads us to trade without first taking the time to build up the requisite knowledge and experience of the markets. Greed forces us into the market too soon when we are unready. Greed also makes us more aggressive, causing us to over-trade or over-leverage, which in turn causes us to trade our account into oblivion.
Fear: Healthy fear is to know that the markets are dangerous and that we first need the requisite skills and training to survive in them. Unhealthy fear is to think that the market is so dangerous that it is paralyzing for us to initiate trades, causing us to watch the market action without being part of it. Unhealthy fear is also when a trader puts in a big order because of greed, and then when the market moves against him, he cuts the trade at a loss too early, fearing a bigger loss yet never allowing the trade room to breathe. Or if the market moves in his direction, he closes the trade too fast with small profits, fearing that the market might move against him yet never allowing the trade room to mature.
Ego: Ego is when any amount of knowledge or experience goes to inflate the head into thinking it knows enough or all there is to know. Many traders lose because they don’t have the remotest idea of what they are doing when at the same time they think they really know. If their ego is big enough and they keep on trading the markets and losing, they may even think that their “experience” qualifies them to write books, create seminars and become “gurus” to those newbies naive enough to trust in their confidence.
The fact is each trade puts one’s forex knowledge and experience under a direct test in the market. Just when you think you know enough, the market will force you to reconsider, go back to the drawing board and learn some more. It is best to be a humble trader, manage your trading in a modest way, and be prepared to learn new things every day and with every trade. One should be prepared for the worst and to learn the most from one’s failures. Too much ego creates perpetual states of illusion and denial and stops the learning process.
Addiction: You know you are a “Trade-aholic” or “Forex-aholic” when you watch charts all day without a break, when you trade with vengeance when you lose, when you are unable to accept a loss keeping losing trades open for days and weeks or adding more money to your account (and even adding to the losing trades) in the hope that it will switch direction. You must remember that trading is not a betting game to make money fast. It is a business to make money slowly and you must put in the time and effort to become a good trader.
Laziness: Most people never use the full potential of their brains. Our brains are more powerful than the most powerful of computers, but it requires work and motivation to flip them on. It is too easy for us to glide through life at low brain output, living in the illusions of the past or future, but unable to fully compute the present and question everything around us. Lazy traders hardly ever do their homework before trading, to research the right setup and the important news of the day, and never do their homework after trading, to analyze their past trades and learn from their mistakes. Instead, their trades are begotten from luck, they end up failing, and there is nothing learned from their trading errors. After failing all the time, they then put all their hopes in a trading robot to trade for them, without putting in the massive effort and testing it takes to distinguish the few good robots from the majority of bad ones.
9. No Trading Plan or Trading System
Many traders trade without a plan or system. They do not define specific risk and profit objectives before trading. Even if they establish a plan, they second guess it and don’t stick with it, particularly if the trade is a loss. Consequently, they overtrade and use their equity to the limit (are under-capitalized), which puts them in a squeeze and forces them to liquidate positions. To trade without a trading plan is to be subject to all the human limitations covered above.
Not following a disciplined trading plan or system leads to accepting large losses and small profits. Many traders do not define offensive and defensive plans when an initial position is taken. They allow emotions to overcome intelligence when markets are going for or against them. They do not have a plan to follow. A good plan must include defense points (stops).
10. Unsustainable or Flawed Money Management
Most forex traders totally forget about the risk of forex trading, thinking only about the win and never planning for the worst. Yet the worst does transpire more than one thinks. Trading without safeguards can be like skydiving without a parachute. Every trade has the potential to sharply turn against you and do so for any amount of time and for any amount of pips. If one is trading with high leverage and without stops, one has no money management in place and is instead vulnerable to having that one trade turn into a nightmare that blows up the account. No amount of praying or hoping or luck or patience can force a bad trade to move back in your favor. They don’t take the small loses and instead stick with the loser until it really hurts, then take the loss. This is an undisciplined approach and a trader needs to stick with a system with a clearly defined stop loss.
Even worse than having no stops, is adding to a losing position via grids and martingales. Some traders compound the problem of trading without a stop loss by adding to their losing trades, either adding the same lot size at different intervals (gridding) or adding a multiple of the initial lot size at different intervals (martingale). While these strategies can sometimes turn bad trades around in one’s favor, they can also accelerate the speed of the blowup if the adverse trade is strong enough.
Money management limits the risk on every single trade so that you are able to trade tomorrow, the next week, months and years in the future. The purpose of money management is to protect you from risking too much and therefore grow your profits in a stable, consistent manner. Without proper money management technique, you can empty your trading account within a few clumsy trades.