The trading journal should contain is a summary of your trading plan or approach, in a statement of intent, listing the type of trades you are intending to pursue. For example, you might note your intention to pursue swing trades in equity indices or FX majors. You should also note your minimum risk-reward ratio and money management rules, such as the percentage of your overall capital you will commit to a trade and the number of concurrent open trades you will allow yourself. Having these guidelines and rules at the top of the journal will act as both a reference and reminder to you going forward and allow you to look back after a period of trading to determine how well you have followed your trading plan.
This is where FX trading began. Ancient merchants needed a common medium of exchange or a basis to value one currency versus another. The simplest way was to compare the cost of a commodity considered valuable in different economies. Various commodities were used, but the one that stood the test of time was gold. If you knew the cost of a fixed amount of gold in economy A as well as within economy B, then you’d have had a very plausible basis from which to decide what the exchange rate between the currencies of A and B should be.
For example, if gold was twice as expensive in currency B versus currency A, then the rate of exchange between the two currencies should have, in theory, been two to one, all other things being equal. Modern markets have become considerably more sophisticated since ancient times, but concepts such as Purchasing Power Parity (a measure of the ongoing spending power of a currency) are still fundamental when it comes to calculating relative FX valuations.
As markets evolved, so did the need to know more about the instruments people traded, and the drivers of the price behind them. At the same time, governments wanted to know as much as they could about the countries they managed and their economies, so they set about gathering as much data as they could. The advent of computers and the emergence of internet technology aided this information-gathering process even further. Market participants were able to gain access to this macro data through the network as it became widely distributed and available in near real time. A standardized economic calendar was formulated with regular release dates for data, and these dates were known in advance.
As with all markets, FX is subject to the flow of supply and demand. Even in instruments that turnover hundreds of billions of dollars per day, we can see these forces at work. Consider the following scenario:
As demand for an instrument rises, the price that market participants are prepared to pay to own that instrument rises in tandem. Sellers of that instrument, at current price levels, are taken out (traded with), or withdraw their orders, and the price rises to a new threshold, which is sufficiently attractive to tempt fresh sellers into the market. Buyers now have the opportunity to trade with sellers at the higher price. If the buyer’s demand outweighs the seller’s supply at this new price level, then the instrument’s price will rise once more. However, if the sellers outweigh the buyers, then the price will fall until it finds a point at which buyers are tempted back into the market.
Trading is a discipline as much as it is a skill. To succeed in trading, we need to create a system or routine that encourages the good habits and discourages the bad. By building a trading plan, you’ll define a set of rules or guidelines that you can always refer back to, allowing you to keep your trading disciplined, systematic and on track.
When we create our trading plan we start with the overarching goal or objective. It’s critical to ask yourself what you want to get out of trading. If your targets or objectives are financial, make sure they are realistic and attainable based on your experience with trading and the time, effort and resources you can commit to it. For example, if one of those goals is to make a million dollars in a year, spending just one hour a week on trading, then, that is not a realistic goal.
The first thing to decide is why you want to take on risk in the first place, and what you want to achieve by doing so. In the context of the financial markets, the answer will most likely be around making money or increasing your capital, and to do so you’re willing to risk some of the money you currently have. That brings us to our first rule which is: you should never speculate with anything other than risk capital, or if you prefer money that you can afford to lose.
Speculation is not the same as investing, particularly when that speculation is undertaken through the use of leveraged products that don’t grant the ownership of the underlying instrument to the speculator or trader.
Correlation describes the mathematical relationship between two or more variables, for example, two financial instruments. Correlations can be positive, where a change in the price of instrument A results in a change in the same direction of the price of instrument B; negative, in which a change in the price of instrument C results in a change in the opposite direction in the price of instrument D; or uncorrelated where the two instruments move independently of each other. Our fourth rule, therefore, is: don’t open multiple positions in different instruments without knowing how they are related.
One of the biggest and most frequent mistakes new traders make is to ignore their own money management and stop loss rules that are designed to protect their capital and keep them in the ‘game’ for the longest possible time. Traders tend to convince themselves acting rationally in doing so, when in fact they’re not. There is a well-documented bias known as loss aversion, whereby traders won’t acknowledge a trade is wrong but rather than closing the position or letting a stop loss take effect as they should, they allow losing positions to remain open, perhaps moving stop losses further out or disregarding them altogether.