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