ForexSpirit

October was the first month since May 2006 that I did not place any live trades.

Looking back at my performance this year it is pretty obvious that I don’t really have any consistency going for me. There have been up months and down months; the downs have generally been bigger and it’s not exactly a trend that I want to see continue.

This chain of events is not exactly surprising considering my blow up at the end of last year. Since then I’ve been trying to find a new path, evidently without too much success given the cold hard numbers on my bottom line.

Instead of digging myself deeper into a hole of my own devising, I’ve decided to revert to demo trading. I still get to keep my toe in the markets and trade, but I don’t risk damaging my equity.

While the scalping method I have been using since last month is nothing revolutionary or even unique I am starting to feel that it suits me well. It incorporates a lot of the components of the BWILC method that I found to be beneficial while also (hopefully) eliminating the weaknesses, which were often directly attributed to my character flaws.

All four parts of the 4×1 methodology exist as part of the scalping method. Let’s go through them in turn:

One currency

Each and every currency is its own animal. Learning the ins and outs of even just one currency takes lots of time and energy. It therefore makes sense when learning to trade to focus on just one currency. There are plenty of traders out there who are quite happy and profitable just trading a single currency pair. There are others who feel more comfortable trading multiple pairs.

I think the key here is that it makes sense to focus on just one until you know it intimately. Only then should you look to expand your repertoire. Even then it continues to make sense to limit the number of markets you monitor to a manageable level.

I traded EUR/USD exclusively for around 18 months (from early 2006 into 2007) before adding currency pairs such as USD/JPY, GBP/USD and AUD/USD. This was a key factor in my subsequent downfall as I failed to properly manage my overall leverage with multiple positions open across more than one currency pair.

I then started to cut back on the number of markets I traded eventually returning to just EUR/USD.

It would certainly be possible to scalp in just one market. At the same time there is nothing really stopping me from trading multiple markets as long as I learnt my lessons from the past and severely restrict having simultaneous positions open in different markets. This point was driven home on October 28 when I had three scalps go sour at once.

GBP/JPY and EUR/JPY are often regarded as prime markets for scalping in as they make decent moves, can be volatile and are still extremely liquid.

To try and marry the best of both worlds I’ve decided to focus on EUR/USD, GBP/USD and EUR/JPY. EUR/USD is my old stalwart. I picked EUR/JPY over GBP/JPY as I have more familiarity with the euro. EUR/JPY is also slightly less volatile than GBP/JPY.

One direction

The second pillar in the 4×1 methodology is determining the long term trend in the market being traded. All trades are taken with the long term trend in mind; this normally means trading exclusively in the direction of the trend. For some it might also involve selective trades against the main trend, catching corrections.

When I traded the pure BWILC method I kept things simple and only traded in the long term trend direction, which at the time was long EUR/USD.

I attempted to trade both with the trend and catch corrections earlier this year but seemed to trip myself up more than anything else. After getting faked out one too many times I reverted back to sticking to one direction at a time.

The direction in which to trade was very much based on the trend evident in the daily and weekly charts from the technical point of view along with the long term fundamental drivers in play.

When you’re trading from 2 or 4 hour charts it makes sense to deduce the long term trend from a higher time frame such as the daily chart.

The scalping I’m now doing focuses on making trading decisions on 1 or 5 minute charts, so while the long term trend is still to be found on the daily charts I’m more interested in the medium term trend which can be found on the 30 minute or 1 hour chart.

This means that I have to be prepared to be trading long one day and short the next. Previously I had been trading in a single direction for months on end, so this constant switching is relatively new for me. How well I’m able to read the medium term trend and act on it will obviously play a crucial part in how successfully I’m able to place my scalp trades. This will be a key issue that I will need to keep an eye on going forward.

One lot

The spectre of leverage being a double edged sword has been raised many times both here on this blog and in other trading circles. It is only when you have been cut deeply as a result of over-leveraged losing trades that you really understand the destructive power that can be wrought by leverage .

For many years I had a healthy respect for leverage. I knew that the 400:1 leverage being offered by some forex brokers was nothing more than bait to draw in the frenzied masses.

Knowing the good and bad that being over leveraged can bestow is not the same as experiencing it. Having respect for high leverage wasn’t enough to save me from myself.

I hope things are different now that I have first hand experience of the destruction that can befall when highly geared trades go significantly against you. I’ve seen my account bleed copious amounts of red almost to the point of being bled dry.

It is no surprise that leverage is a critical part of my trading plan. It then comes down to finding the right balance between having low enough leverage so that a string of losses won’t wipe you out while at the same time making use of leverage in a constructive way to help build your account over time.

The general rule of thumb is the lower the better. You don’t want to be using leverage high enough so that every pip move gives you a nosebleed. You’ll often see recommendations that your leverage should be low enough that you have no trouble sleeping if you have an overnight trade or two still open. I can see the sensible advice that is being imparted here but I also generally feel that if the leverage is too low then you can lose your attachment to the trade.

The trick comes in finding the biting point between leverage so high that you start to enter gambling territory (your risk of ruin chance is too high) and so low that you become completely blasé about what trades you have open.

It is also no good just looking at the gearing of any individual trade, you must also consider and make rigid plans for the maximum gearing that you will allow across multiple open trades.

You might think you’re being conservative by only using 1:1 gearing on any one trade but you can still become unstuck very quickly if you end up having 20 trades open at once.

The number of currency pairs being traded and the expected frequency of opening new trades end up being important inputs into any determination of leverage.

All of these factors have gone into my decision making to use 3:1 as my gearing ratio for scalp trades.

My preference is to have only one scalp trade open at any one time. I am not adverse to having multiple trades open at once but it needs to handled carefully. For example, I might be in a trade that went immediately into the red and price has reached a new support or resistance level that I think it worth scalping from. Similarly, I might be in a losing trade in one currency pair while I spot a good opportunity in another. I want new entries to be separated by time as well as price.

I have a money management rule now where I do not want the unrealised losses from all open trades go beyond 7% of my account equity. If that line in the sand is crossed then I am just going to close all open trades, accept the loss and move on. This means that if I have two trades open that each trade has much less room to breathe than if there was just a single trade active. This is a powerful incentive to make sure that I limit myself to only having one trade open at any one time whenever possible.

While there might seem to be powerful reasons to make it an iron clad rule to only ever have one trade open at once, there is one very beneficial reason to allow for the odd, sparing simultaneously open trades and that is the concept of keeping the scoreboard ticking. This means being able to still pull in money from winning scalp trades even while enduring drawdown on an open trade. This can be a very useful tactic if a losing trade has to be held for a protracted period of time.

The trades taken while holding the loser can help to offset an unrealised loss that is finally realised (that either hits its stop loss or is closed out manually when it is decided the trade has no chance of recovery). Alternatively, if the loser does come back and close at breakeven or even with a profit it means that time was not lost waiting for it to do so. Points (money) were added to the scoreboard (account balance) all the while. This ties in directly with the final point in the 4×1 methodology.

One percent

Perhaps the most controversial part of the BWILC method lies in how it flies in the face of some conventional trading wisdom. Instead of advocating that you let your winners run and cut your losses short you are instead advised to take your profits quickly and ride out your loses.

The ‘one percent’ component refers to targeting a one percent increase in your account equity for a winning trade. Don’t look for each winner to shoot to the moon and provide you with a big gain.

Instead look for small, frequent, steady gains that help your account balance to creep up over time.

If your trade is in the red but was taken in the direction of the long term trend then holding that trade open to see if the long term trend resumes is a valid strategy, as long as you have hard and fast rules as to know when to abandon all hope and just take the loss. I’ve discussed many times in the past how the BWILC strategy aims to offset these sorts of large losses with larger gains, so I won’t go over the same ground here again.

I have applied the same sort of mindset to my scalping approach. I shoot for small, frequent winners, often booking around 10 pips of profit, while letting my losers hang out there to see if the medium term trend will pull them back into the black.

I have a fixed stop loss in place on each trade so I know what my maximum exposure is for any one trade. This stop loss is placed where it would result in a 5-7% loss, hopefully beyond a significant support or resistance level. 7% is the maximum allowed drawdown level before booking the loss but if it can be placed in a sensible location before that then why not do that. Allowing for a little more than a 5% move provides for enough wiggle room for price to get caught in the randomness vortex before hopefully moving back in the trade’s direction as the predominant trend takes hold again.

No big winners are booked with the scalping method, so how are the big losses recuperated?

It all comes down to the increased frequency in trading. When I was trading the pure BWILC method I would generally average about two trades a week.

Although I have only been trading using the scalping method for a few weeks, it seems reasonable to estimate that I’m making 30-40 trades a week. The vast increase in the number of trades allows for loses to recuperated quickly as long as the number of losing trades is minimal.

I have some very ambitious goals for this trading strategy. For a long time I was very conservative in my trading goals. If all the professional money managers and hedge funds out there struggled to make more than 30% a year consistently, then it seemed like pure folly to aim for more than that. To that end I was happy with a 3% monthly return.

I started to get myself into trouble when I bumped up my monthly goals to 10% in August 2007. I almost doubled the leverage I placed on each individual trade and expanded the number of markets I looked at from one to three. What I didn’t do was properly manage my downside risk.

I think it’s important to keep the lofty goals as by being an active trader I’m looking to create wealth not just preserve it. Maybe I’m crazy but I think it might be worth targeting a 20% monthly return with this scalping method.

Here are the back-of-the-napkin rough figures that I’m working from.

Let’s work with an average of 5 trades a day, where each trade returns 0.3%. If all 5 trades are profitable that results in a 1.5% return for the day.

My goal is to have no more than one losing trade in a week and one that is closed out for no more than a 100 pip loss. This is a pretty big assumption right now but I see no reason why it could not be possible. Of course there will be weeks with bigger and/or more frequent losers but on the flip side there can also be weeks with no losers at all.

Anyway, let’s stick with a single 100 pip loss per week for this example. It’ll take 10 profitable trades to negate the loss, which means that two days are used up to combat the losing trade. That’s leaves the remaining three days of the week which results in a 4.5% gain for the week.

Position sizing is re-jigged over the weekend which means that weekly gains can be compounded to calculate the monthly return.

Let’s say there are just 4 weeks in a month. A 4.5% weekly return compounded over 4 weeks results in a gain of 19.25%.

A 20% monthly target is therefore not out of the realms of all possibility.

Now it’s just a case of turning this goal into a reality…