Learning how to trade Forex successfully is certainly not a random endeavor, it is a structured approach based on planning, executing, reviewing, and adjusting the plan as necessary. The continuous application of this cycle allows us to have a beneficial trading mindset and behavior which leads to consistent profits, the ultimate goal of every beginning trader.
Here are three critical metrics that every trader should keep an eye on and use to assess his/her performance.
This is simply the average profits from all the winning trades divided by the average losses from all the losing trades. A “Profit Factor” higher than 1 means the account is growing, and a value of less than 1 means the trading account is shrinking. A trader should aim for a value of 1.5 or higher. The reason this metric is such a valuable one is because it can replace two other metrics, the “Reward-to-Risk Ratio” and the “Win-Loss Ratio”, as neither of them on its own can tell us if the trader is being profitable or not.
This is the average number of pips gained or lost across all the trades taken. Day traders should focus on the “Average Pips per Day”, swing traders on the “Average Pips per Week”, and position traders on the “Average Pips per Month”. A good benchmark to aim for is an average of +30 pips per day for day traders, +200 pips per week for swing traders, and +1,000 pips per month for position traders. Once a trader identifies his average number of pips and builds confidence in his ability to achieve this average over and over, all he has to do is increase his position size to increase his profits.
This is probably the single most important metric to monitor, and it’s the percentage of trades that were executed as per plan without any deviations. In order to develop this metric, every trade without exception should be reviewed and assessed whether it was as per plan or not, and if possible take a snapshot of the trade setup and save it as a picture file for later review. A professional trader is easily capable of achieving 95% or higher, and that is what every beginning trader should aim for.
Monitoring these three metrics and taking corrective actions based on their values is a crucial exercise that every trader needs to perform in order to climb the ladder of consistent profits.
FOREX RISKS
The trading of foreign exchange currencies involves risks. The evaluation of the grade or severity of risk should always be taken into account before executing a trade.
The following are the major risk factors in FX trading:
- Exchange Rate Risk
- Interest Rate Risk
- Credit Risk
- Country Risk
- Liquidity Risk
- Marginal or Leverage Risk
- Transactional Risk
- Risk of Ruin
Exchange Rate Risk
Exchange rate risk is the risk involved based on the effect of the continuous and usually volatile shift in the worldwide market supply and demand balance on an outstanding foreign exchange position. For the period the trader’s position is outstanding, the position is subject to all price changes. This risk can be quite substantial and is based on the market's perception of which way the currencies will move based on all possible factors that happen (or could happen) at any given time, anywhere in the world. Additionally, because the off-exchange trading of Forex is largely unregulated, no daily price limits are imposed as exist for regulated futures exchanges. The market moves based on fundamental and technical factors - more about this later.
Interest Rate Risk
Interest rate risk refers to the profit and loss generated by fluctuations in the forward spreads, along with forward amount mismatches and maturity gaps among transactions in the foreign exchange book. This risk is pertinent to currency swaps; forward outright, futures, and options. To minimize interest rate risk, one sets limits on the total size of mismatches. A common approach is to separate the mismatches, based on their maturity dates, into up to six months and past six months. All the transactions are entered in computerized systems in order to calculate the positions for all the dates of the delivery, gains and losses. Continuous analysis of the interest rate environment is necessary to forecast any changes that may impact on the outstanding gaps.
Credit Risk
Credit risk refers to the possibility that an outstanding currency position may not be repaid as agreed, due to a voluntary or involuntary action by a counterparty. Credit risk is usually something that is a concern of corporations and banks. For the individual trader (trading on margin), credit risk is very low as this also holds true for companies registered in and regulated by the authorities in G-7 countries. In recent years, the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) have asserted their jurisdiction over the FX markets in the US and continue to crack down on unregistered FX firms. Countries in Western Europe follow the guidelines of the Financial Services Authority in the UK. This authority has the strictest rules of any country in making sure that FX companies under their jurisdiction are keeping qualified customer funds secure. It is important for all individual traders to thoroughly check out companies before sending any funds for trading. It is fairly easy to check out the companies you are considering by visiting the authorities' websites: The CFTC's website is http://www.cftc.gov/, the NFA website is http://www.nfa.futures.org/, and the FSA's website is http://www.fsa.gov.uk/. Most companies are happy to answer inquiries from customers and often post notices pertaining to security of funds on their website. It should be noted, however, that minimum capital requirements for Futures Commission Merchants ("FCMs") registered with the CFTC are much less than those of banks, and under present CFTC regulations and NFA rules, protections related to the segregation of customer funds for regulated futures accounts do not extend fully to funds deposited to collateralize off-exchange currency trading. For these and other reasons, the CFTC and NFA discourage any representation that the registration status of a Futures Commission Merchant substantially reduces the risks inherent in over-the-counter Forex trading.
Dictatorship Risk
Dictatorship (sovereign) risk refers to a government's interference in the Forex marketplace. Although theoretically present in all foreign exchange instruments - currency futures are, for all practical purposes, exempt from country risk, for the reason that the major currency futures markets are located in the US.
Counter-party Default Risk
Over-the-counter ("OTC") spot and forward contracts in currencies are not traded on exchanges; rather, banks and FCM's typically act as principals in this market. Because performance of spot and forward contracts on currencies is not guaranteed by any exchange or clearing house, the client is subject to counter-party risk -- the risk that the principals with a trader, the trader's bank or FCM, or the counter-parties with which the bank or FCM trades, will be unable or will refuse to perform with respect to such contracts. Furthermore, principals in the spot and forward markets have no obligation to continue to make markets in the spot and forward contracts traded.
Country and Liquidity Risk
Although the liquidity of OTC Forex is in general much greater than that of exchange traded currency futures, periods of illiquidity nonetheless have been seen, especially outside of US and European trading hours. Additionally, several nations or groups of nations have in the past imposed trading limits or restrictions on the amount by which the price of certain Foreign Exchange rates may vary during a given time period, the volume which may be traded, or have imposed restrictions or penalties for carrying positions in certain foreign currencies over time. Such limits may prevent trades from being executed during a given trading period. Such restrictions or limits could prevent a trader from promptly liquidating unfavorable positions and, therefore could subject the trader's account to substantial losses. In addition, even in cases where Foreign Exchange prices have not become subject to governmental restrictions, the General Partner may be unable to execute trades at favorable prices if the liquidity of the market is not adequate. It is also possible for a nation or group of nations to restrict the transfer of currencies across national borders, suspend or restrict the exchange or trading of a particular currency, issue entirely new currencies to supplant old ones, order immediate settlement of a particular currency obligations, or order that trading in a particular currency be conducted for liquidation only. OTC Forex is traded on a number of non-US markets, which may be substantially more prone to periods of illiquidity than the United States markets due to a variety of factors.
Leverage Risk
Low margin deposits or trade collateral are normally required in Foreign Exchange, (just as with regulated commodity futures). These margin policies permit a high degree of leverage. Accordingly, a relatively small price movement in a contract may result in immediate and substantial losses in excess of the amount invested. For example, if at the time of purchase, 10% of the price of a contract were deposited as margin, a 10% decrease in the price of the contract would, if the contract were then closed out, result in a total loss of the margin deposit before any deduction for brokerage commissions. A decrease of more than 10% would result in a total loss of the margin deposit. Some traders may decide to commit up to 100% of their account assets for margin or collateral for Foreign Exchange trading. Traders should be aware that the aggressive use of leverage will increase losses during periods of unfavorable performance.
Transactional Risk
Errors in the communication, handling and confirmation of a trader's orders (sometimes referred to as "out trades") may result in unforeseen losses. Often, even where an out trade is substantially the fault of the dealing counter-party institution, the trader/customer's recourse may be limited in seeking compensation for resulting losses in the account.
Risk of Ruin
Even where a trader/customer's medium to longer term view of the market may be ultimately correct, the trader may not be able to financially bear short-term unrealized losses, and may close out a position at a loss simply because he or she is unable to meet a margin call or otherwise sustain such positions. Thus, even where a trader's view of the market is correct, and a currency position may ultimately turn around and become profitable had it been held, traders with insufficient capital may experience losses.
