Forex trading can be a gateway to both great opportunity and risk and its low barriers of entry attract countless new traders every day. As with any new venture, though, there are some common pitfalls and traps that newbies tend to fall into.
In this article, we’ll explore some of the most common mistakes made by new forex traders – and teach you how to avoid them.
1. Trading Without A Plan
One of the most common mistakes made by beginning forex traders is trading without a plan. The global financial markets are highly complex and unpredictable and it is a mistake to try to navigate them purely on instinct and emotion. When you act without a plan, however, that is exactly what you are likely to wind up doing. Creating and sticking to a properly designed forex plan can be difficult for a variety of reasons but virtually every trading expert will tell you that not doing so is a mistake. Before you start trading with real money, ensure that you have a proper plan and that you have tested it thoroughly (our risk-free Demo trading accounts are a great place to do this). You should enter and exit trades based on your trading plan while minimizing your total risk on each trade.
Most beginner forex traders fall into the trap of using a trading plan with a low win rate. Your win rate basically refers to the number of your winning trades as a percentage of all your trades. For example, if you typically win six trades out of every ten trades that you make, this translates into a 60% win rate. For a beginner, it is important that you keep track of your win rate and to make sure you keep it above 50% in order to remain profitable. Your win rate is also closely associated with your risk/reward ratio, which is discussed below.
Another common mistake made by beginning forex traders is using a trading plan with a poor risk/reward ratio. Your risk/reward ratio is basically the a ratio of the amount you want to risk on each trade compared to the profit target that you are targeting. For example, you might aim to risk only 10 pips for a potential profit of 30 pips, which translates into a risk reward ratio of 10:30, or 1:3. You can also calculate your risk/reward ratio in terms of the money you risk on each trade and the potential profit per trade. To be an effective trader, you should always aim for a risk reward ratio of 1:2 or higher.
Most beginner traders make the mistake of forgetting to put a stop loss order on their trades. A stop loss order is basically an instruction to your forex broker to close your trade if it turns unprofitable. You should set a stop loss order on every trade that you make in order to limit your risk should things not go your way. You can learn more about stop loss orders here.
The basic elements of position sizing has been covered in the previous sections of this article, specifically the parts on stop loss orders and adhering to a sustainable risk/reward ratios. Proper position sizing is a combination of both, but focuses on the total amount you risk on each trade. Professional traders recommend that you only risk about 1% of your trading bank on each trade, which means that your stop loss order should never exceed this percentage of your trading account.
Prudent traders know when to cut their losses after making a bad trade. It can be a natural instinct to do the opposite – to invest more money in the hopes that the trade will turn profitable again and you will make your money back as a result. Doing this often results in simply compounding your losses, however. Smart and experienced traders usually cut their losing trades short and might even initiate opposite trades to profit from the new trend. You should never add to your losing trades.
Many new traders start trading forex with a goal of becoming rich in a short period of time. This is a critical mistake and is one of the leading reasons why these traders generally end up wiping out their accounts within a month or two. The most successful traders treat their trading as a profession and spend a lot of time and effort developing their knowledge and skills. Discipline, patience, and lots of practice on Demo or similar accounts are key to developing as an effective forex trader.
Many beginner traders make the crucial mistake of not keeping a trading journal and wind up making emotional and erratic decisions as a result. Keeping a trading journal can help you build your emotional strength and help you make better and more rational trading decisions. You should make sure that you record all your trade entries, exits, profits, losses, and reasons for all your actions on a particular trade. You can learn more about the benefits of trading journals here.
It’s important to remember that trading is an inherently risky activity and avoiding the pitfalls outlined above alone will not guarantee you success. Following these tips will, however, help you develop as a trader and aid you in your ultimate goal of forex success. As with anything, learning to trade takes time and effort and the more of both you put in, the more positive results you are likely to see.