Forex Walkthrough

AAA

Trading Rules - Being Right but Being Early Simply Means That You Are Wrong

by Boris Schlossberg and Kathy Lien

There is a great Richard Prior routine in which the comic lectures the audience about how the only way to respond when your spouse catches you cheating red-handed is by calmly stating, "Who are you going to believe? Me? Or your lying eyes?" While this line always gets a huge laugh from the crowd, unfortunately, many traders take this advice to heart. The fact of the matter is that eyes do not lie. If a trader is short a currency pair and the price action moves against him, relentlessly rising higher, the trader is wrong and needs to admit that fact - preferably sooner rather than later.

Analysis of the EUR/USD 2004-2005
In FX, trends can last far longer than seem reasonable. For example, in 2004 the EUR/USD kept rallying - rising from a low of 1.2000 all the way to 1.3600 over a period of just two months. Traders looking at the fundamentals of the two currencies could not understand the reasons behind the move because all signs pointed to dollar strength.

True enough, the U.S. was running a record trade deficit, but it was also attracting capital from Asia to offset the shortfall. In addition, U.S. economic growth was blazing in comparison to the Eurozone. U.S. gross domestic product (GDP) was growing at a better than 3.5% annual rate compared to barely 1% in the Eurozone. The Fed had even started to raise rates, equalizing the interest rate differential between the euro and the greenback. Furthermore, the extremely high exchange rate of the euro was strangling European exports - the one sector of the Eurozone economy critical to economic growth. As a result, U.S. unemployment rates kept falling, from 5.7-5.2%, while German unemployment was reaching post-World War II highs, climbing into the double digits.

What If You Took a Short Position and Exited Early?
In this scenario, dollar bulls had many good reasons to sell the EUR/USD, yet the currency pair kept rallying. Eventually, the EUR/USD did turn around, retracing the whole 2004 rally to reach a low of 1.1730 in late 2005. But imagine a trader shorting the pair at 1.3000. Could he or she have withstood the pressure of having a 600-point move against a position? Worse yet, imagine someone who was short at 1.2500 in the fall of 2004. Could that trader have taken the pain of being 1,100 points in drawdown?

The irony of the matter is that both of those traders would have profited in the end. They were right but they were early. Unfortunately, in currency markets, close is not good enough. The FX market is highly leveraged, with default margins set at 100:1. Even if the two traders above used far more conservative leverage of 10:1, the drawdown to their accounts would have been 46% and 88%, respectively.(Learn more about forex leverage with, Forex Leverage: A Double Edged Sword.)

Right Place, Right Time
In FX, successful directional trades not only need to be right in analysis, but they also need to be right in timing as well.. That's why believing "your lying eyes" is crucial to successful trading. If the price action moves against you, even if the reasons for your trade remain valid, trust your eyes, respect the market and take a modest stop. In the currency market, being right and being early is the same as being wrong.

Know the Difference Between Scaling In and Adding to a Loser
Related Articles
  1. Forex Education

    These Are The Best Hours To Trade the British Pound

    The best times to trade the British pound are centered around economic releases at 1:30 am, 2:00 am, 8:30 am and 10:00 am U.S. ET.
  2. Mutual Funds & ETFs

    ETF Analysis: iShares Morningstar Small-Cap Value

    Find out about the Shares Morningstar Small-Cap Value ETF, and learn detailed information about this exchange-traded fund that focuses on small-cap equities.
  3. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  4. Trading Strategies

    How To Buy Penny Stocks (While Avoiding Scammers)

    Penny stocks are risky business. If want to trade in them, here's how to preserve your trading capital and even score the occasional winner.
  5. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  6. Stock Analysis

    Investors Need to Stop Shorting GoPro. Here's Why

    Discover why investors should stop shorting GoPro. GoPro has been one of the fastest-growing companies since 2005 with many betting against more growth.
  7. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
  9. Investing Basics

    5 Things to "Deliberately" Do to Improve Your Trading

    Most traders are putting in trading hours, but not improving. Here are deliberate steps that can take your trading to the next level.
  10. Chart Advisor

    Stocks to Short...When the Dust Settles

    Four short trades to consider, but not quite yet. Let the dust settle and wait for a pullback to resistance for a higher probability trade.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  3. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  4. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  5. Debt Ratio

    A financial ratio that measures the extent of a company’s or ...
  6. Price-Earnings Ratio - P/E Ratio

    The Price-to-Earnings Ratio or P/E ratio is a ratio for valuing ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  3. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  4. What assumptions are made when conducting a t-test?

    The common assumptions made when doing a t-test include those regarding the scale of measurement, random sampling, normality ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. What is the difference between the return on total assets and an interest rate?

    Return on total assets (ROTA) represents one of the profitability metrics. It is calculated by taking a company's earnings ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!