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. Trading

    Top Reasons Forex Traders Fail

    This market can be treacherous for unprepared investors. Find out how to avoid the mistakes that keep FX traders from succeeding.
  2. Trading

    8 Basic Forex Market Concepts

    We go over some of the things you need to understand before you can trade currencies.
  3. Trading

    Forex Trading: A Beginner's Guide

    Learn about the forex market and some beginner trading strategies to get started.
  4. Trading

    What Type Of Forex Trader Are You?

    Timing may be the key to uncovering your true strength as a forex trader.
  5. Trading

    How Much Leverage Is Right for You in Forex Trades

    It isn’t economics or global finance that trip up first-time forex traders. Instead, a basic lack of knowledge on how to use leverage is at the root of trading losses.
  6. Trading

    Top 7 Questions About Currency Trading Answered

    Whether you're puzzled by pips or curious about carry trades, your queries are answered here.
  7. Trading

    Adding Leverage To Your Forex Trading

    The use of margin to trade in the foreign exchange market can magnify profit opportunities.
  8. Trading

    Top 5 Reasons To Invest In Currencies

    Here's why you should get into the forex market.
  9. Trading

    How Much Trading Capital Do Forex Traders Need?

    Even a small pip profit can mean substantial percentage returns over time.
  10. Trading

    Stop Hunting With The Big Forex Players

    Learn to bank short-term profits by placing stops away from the crowd.
Frequently Asked Questions
  1. Depreciation Can Shield Taxes, Bolster Cash Flow

    Depreciation can be used as a tax-deductible expense to reduce tax costs, bolstering cash flow
  2. What schools did Warren Buffett attend on his way to getting his science and economics degrees?

    Learn how Warren Buffett became so successful through his attendance at multiple prestigious schools and his real-world experiences.
  3. How many attempts at each CFA exam is a candidate permitted?

    The CFA Institute allows an individual an unlimited amount of attempts at each examination.Although you can attempt the examination ...
  4. What's the average salary of a market research analyst?

    Learn about average stock market analyst salaries in the U.S. and different factors that affect salaries and overall levels ...
Trading Center