How to Avoid This Common Trader Trap

Thanks for the amazing response to Ichimoku charts last week. It seems that plenty of you are fired up and ready to start trading this way.

Given the huge volume of emails and questions I’ve had about Ichimoku, I thought I’d follow up next week with some more info.

Of course, the charts I picked last week were ones that would really demonstrate how Ichimoku signals work… But, like any other indicator, they have their weaknesses.

You’ll find lots of conflicting advice about how Ichimoku can’t be used on Forex; or how it doesn’t work on short-term charts…

So I’ll take a look at where Ichimoku charts can let us down, and how we can protect ourselves against these weaknesses.

So please watch out for my email next week covering these.

This week I want to focus on a slow, painful torture…

(One that most traders will recognize only too well.)

It looks something like this…

… win, win, loss, win, loss, win, loss, loss, loss, win, loss, loss …

There’s an anecdote about how a frog placed in boiling water will jump out, but if it’s placed in cold water that’s gradually heated, it will be unaware of the danger and be cooked to death.

Anyone who’s slowly, slowly experienced their trading account move further and further into negative territory will know what I’m talking about.

Hit a 20% drawdown, and it hurts; but trying to come back from a 50% drawdown and you’ll need to double your money before you’re back on the starting block.

I can’t stress enough how important it is for you to protect yourself from these scenarios.

The number one way to do this is to consider how much you risk on a trade.

If you’re a day trader, jumping in and out of trades several times a day, you shouldn’t be risking more than 1% per trade.

Why? Because the more time you’re putting yourself ‘out there’, the more your money is at risk from market volatility.

So, if you’ve a fund of £5,000 and a stop level of 20 pips, then you shouldn’t be staking more than £2.

There are two factors that cause traders to over-stake: wanting to make more money, faster; and being limited by the minimum stakes of their broker.

If you’ve a trading fund of £500, a stop level at 25 pips, and a broker with a minimum stake of £1, you’re not going to be able to trade that strategy without risking 5% per trade.

But there are brokers out there who’ll over-lower stakes – I’ve covered them in previous newsletters: brokers who’ll go down to 10p per pip. Stick with one of these, and you can comfortably get trading with very modest funds.

If you’re trading less frequently, then you may be risking a little more per trade: 2% or 3% – but not more.

Remember, this is all about you protecting yourself from that win, loss, win, loss ‘death by a thousand cuts’.

The idea is to contain drawdowns to no more than 25–35% so that you have a realistic chance of recovery. You don’t want to suddenly find yourself 50% down, needing to make 100% just to get even.

Are there ever exceptions?

The areas where you can push your risk levels highest are in very high-probability set-ups.

There are some strategies out there with win rates around 70–80% – here you can afford to push your risk higher (I’m talking about 3–5% – no higher).

But bear in mind that these strategies tend to have a low reward-to-risk ratio, so when those rare losses come along they can be hefty. As long as you’ve planned for this – fine.

Hedged trading is a contentious one as regards risk – and it’s difficult to manage and plan for the downside of these trades.

(If you’re not familiar with hedged trading – it’s where you pick two closely matched instruments – you buy one, and sell the other at the same time, hence protecting yourself from market behaviour, usually while profiting from any minor price discrepancies you’ve spotted between the two.)

But, just because your trade is hedged, doesn’t mean that you can show a flagrant disregard for risk.

Hedging manages risk in a different way, but that doesn’t make it risk-free. If you’re hedged trading without any stop loss, then it’ll only take one catastrophe for you to be wiped out.

‘Catastrophe’ is a difficult risk to quantify, which is why we often see it being ignored by traders, by businesses, and individuals… It’s why big oil companies fail to invest in safety measures, only to be hauled up when disaster strikes; and why politicians fail to invest in flood defenses…

So, even if your hedge is rock-solid, I’d advise to still always use some form of stop loss.

Surviving the thousand cuts

Whatever type of strategy we’re following, we can’t avoid the cut, cut, cut of the losing trade, digging away at our profits. But if we’re going to survive these, we must take a very defensive view of risk.

My advice is to always trade as if your worst losing run is about to begin… It might not put in the most positive frame of mind, but it’ll force you to take risk management seriously… and you’ll be pleasantly surprised when you get a winner!

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