Trading price action: random distribution of winning and losing trades
One of the most important aspects of forex trading that many traders don't seem to know is that they should never expect a specific trade to be either profitable or unprofitable. This may seem weird, but this is important. Even if you have a trading strategy that has an identified rate of success, you still don't know when your advantage will result in a winning trade or a losing one. Think about it, if you've had a 65% success rate in the past few weeks, you cannot know which trade will fall in the 65% win column and which will fall in the 35% losing column. You don't know, and you can never know. You want to know why? This is because in trading, there is a random distribution of winning and losing transactions, regardless of your trading edge!
Here's an example of what a random distribution of winning and losing trades might look like. Note that as the curve increases over time, this means that the trading strategy used is an effective and profitable strategy over a period of time. The implications of this situation are profound:
The implications of trading performances distributed randomly
If you truly understand and have processed the reality that your trading results are distributed randomly, you will never risk more money than you are comfortable losing on a single forex trade. In fact, traders who believe that they never know in advance whether a trade will win or lose never behave as if they knew the outcome in advance.
Traders who risk more than they feel comfortable losing on a trade behave as if they know they will win in advance. It is perhaps this attitude and this belief that puts traders in the worst position. If you trade taking into account that your results are distributed randomly, you will always be aware of the risk you are taking and you will always assess the potential risk of the trade before entering it, rather than just thinking about the expected profit.
How your expectations can hurt your account balance
It's human nature to want to win every trade; after all, we have an innate need to be right and to feel that we are in control of things. This is why most people are more afraid of flying than driving, although statistics show that flying is much safer; people like to feel like they are in control of the situation.
The problem with trading is that you have to express all of your expectations for a given trade, and for most traders this is almost impossible. When you lose a trade, several things happen: 1) you make a mistake regarding the direction of the market, and 2) you lose some of your money.
We have to learn that losing money and being wrong about the market's direction are both "part of the game". You have to remember that forex trading is a trading activity, but the costs are a little different from those of most other businesses. Your costs are quite direct and you can see them. You must learn to ignore these things and not let them affect you.
Expectations kill most traders. You must learn to free yourself from all of your expectations regarding a given trade; instead, you need to have long-term expectations. For example, it's good to expect to be profitable at the end of the year if you follow your plan and trade with discipline and patience. On the other hand, it's not good to expect to win every single trade. The reason is that it doesn't matter that you win on the next trade, but that you are disciplined and only trade when you are ahead and keep your risk level under control. If you do these things consistently, you can expect to make money in the long run. But most traders are emotional and overload their accounts because they expect every trade to be successful. When you expect to win each trade, you're like an emotionally charged freight train heading towards a brick wall of reality - when your expectations don't translate into reality, you become emotional, and when you become emotional when trading, you will lose money!
Real-life examples of trading outcomes that are randomly distributed
Ok, now that we've discussed theory, let's look at the real world. I'd like to review some recent examples of price action trading in the real environment. The following examples are only meant to introduce the notion of random distribution and to prove the fact that we never know when we are going to have a winning or losing trade.
Daily gold chart
On this daily gold chart, we can see examples of three different configurations of price action trading.
1) This trading configuration with a pin bar forms a key support level. Even though it goes against the trend, the configuration is still valid and obvious, so it's a valid example of our trading edge thanks to a price action analysis. However, this configuration ends up losing, because we the support is then briefly broken through, before a reversal just below the lowest level of the bar, which forms another pin bar from this same support level. So, even though the configuration is valid and obvious, it results in a losing trade. You therefore have to realise that you won't win every trade!
2) Another pin bar, on the same support level as in the previous configuration is at $1,531. Which makes it another valid example of our trading edge. After a 50% retracement of the pin bar, the market started to rise again and gave us a winning trade. Again, there is no reason to expect it to be a winning trade, it was just an example of our trading advantage: price action.
3) Afterwards, we can see a well defined false break that has formed with a bar pin. This is a configuration that is formed from a key resistance level, so it is certainly a valid example of our trading edge. We can then see that the price quickly drops and that provides us with a nice profit, especially if you enter close to the pin bar's 50% retracement, it is a very effective entry technique based on Fibonacci ratios. All of these configurations are valid examples of our trading advantage, two of which proved to be successful and the other one a loser.
AUD/USD chart
On this daily AUD/USD chart, we can see examples of three different price action configurations. Let's review them one by one.
1) The first configuration shows two pin bars that form consecutively, so even if you missed the first one you can take the second one since they both formed at a key support level. We can see that a big winning trade could be made depending on the placement of the stop loss level - the risk/reward ratio could be 1:3 or 1:4 or even higher. However, many people might expect these pin bars to lose as they go against the recent downward trend. But it is a valid configuration to counter the trend. Don't expect to win or lose on a single trade, just stick to your trading edge and your trading plan, and realise that if you do that, you will win quite a few trades.
2) This is a well defined reversal pattern with a bearish pin bar that would likely have resulted in a losing trade for most traders. Even if this trade is a loser, don't get carried away by emotion or anger, because our winning and losing trades are distributed randomly - we shouldn't attach any expectations to a particular trade.
3) This pin bar is smaller, but it shows the rejection of a solid resistance level, and after the previous huge price rise, many traders would have taken this sell signal. We can see that the market does eventually go down, but then it goes back up to test the resistance level again, which would have caused most traders to lose. So on this chart, we have a big winning trade with a profit potential of 3x or 4x, then two losing trades of 1x each, and as you can see, we would still have a net profit at the end of this series of trades.
EUR/JPY chart
On this daily EUR/JPY chart, we can also see 3 examples of price action configurations.
1) This setup is a bar pin with a long wick that bounces off of a long-term support level close to 97.00-96.00. Note that the price has rebounded considerably on this bar pin, which gives us a very good profit potential compared to the overall risk.
2) This pin bar configuration ends up losing, even though the entry is made after the close of the bar or on a limit entry close to the 50% retracement of the bar. However, this bar pin is valid since it forms near a key support level, at 98.70-98.50, and it meets the general definition of a pin bar. However, there is no reason to expect it to win or lose since we know our results are distributed randomly; just follow your plan and, when a valid configuration is formed, you trade on it and let the market do the rest.
3) Next, we can see an inside bar pattern that forms just below the resistance level near 101.40. Note that this configuration then deteriorates sharply, so with a stop near the 50% retracement of the mother bar, the risk/reward ratio is very good.
If you don't expect to win every single trade, you might end up being a winning trader!
The reasons why so many traders have a hard time making money on a regular basis basically boils down to the fact that they have unreasonably high expectations. Most traders strive to control all aspects of their activity, whether they are aware of it or not. In reality, you can't control the market - all you can do is control yourself. But it is harder to control your own actions and thoughts than to overbid or take too many risks on a trade because you have convinced yourself that "this specific trade" will win.
You have to admit to yourself that you're the cause of your trading problems. It's not your broker's fault, it's not the market's fault, it's your fault if you're losing money, and you probably lose money because you expect to win on each trade and you therefore tend to ignore the risks involved in trading. Traders tend to focus too much on potential profits and not enough on the risk component. However, as I mentioned above, the potential to win or lose on a trade is essentially the same. Winning and losing trades are distributed randomly, and you can only assign an overall profit percentage to your trading strategy over a long series of trades.