I wrote this article as a follow up to the article I wrote about the Commitments of Traders vs. Retail Traders Long Short Ratio's as an attempt to provide an explanation as to why the majority of small retail Forex traders are usually wrong, by wrong I mean trading against the larger underlying trend.
One statistic that's often floated round on the Internet is that '95% of Forex traders fail'. When the question why do 95% of Forex traders fail is asked, the answers usually range from everything from bad money management, to cutting winners to soon and letting losers run, to the spread (which is often blamed for making trading a 'negative sum game'), to simply saying that they don't know how to trade. But there is more to it than that as looking at the sentiment indicators of a broker that publishes the open position ratios of its retail clients will likely show.
Monitoring the open position ratios from the likes of OANDA and FXCM reveals that the majority of retail traders are usually on the wrong side of the larger underlying trend (and hence wrong). If it were merely a case of retail traders being uninformed and effectively picking a side at random due to ignorance and then losing due to bad money management or any of the other reasons that are normally sighted as reasons for their failure, then at any given time I would expect the open positions ratio to be around 50/50. But it's not like this at all, the retail Forex crowd is astonishingly accurate in it's ability to be on the wrong side of the larger underlying trend, with the more extreme the ratio of longs to shorts and the stronger the trend, the more likely the crowd is to be on the wrong side of the trend and the big move that usually follows these extremes.
The Reason: My Theory,
I believe there are two main reasons why the majority of small traders are usually wrong, the first has to do with the traders themselves and their style of trading, and the second has to do with the market mechanics. My theory could be summed up by quoting two sayings –
"When everyone wants to buy the market must fall as there is nobody left to sell. When everyone wants to sell the market must rise as there is nobody left to buy. – An old contrarian saying.
For a market to trend it needs to deceive and shakeout the majority of traders – Soso, my favourite poster on ForexFactory.com.
The first reason is that most retail traders are essentially gamblers trying to pick tops and bottoms rather than follow the actual direction of the market. These traders are also fairly short-term and they typically use tiny stop losses that are far too small (to hear of retail traders using stop losses of anything from 20 – 50 pips is not uncommon at all). Picking exact tops and bottoms is damn near impossible (which is why using tiny stops is a bad idea, you can be right and still be stopped out) but that doesn't seem to stop the retail Forex crowd trying. Large successful speculators on the other hand don't usually try to pick tops and bottoms with 50 pips stop losses and 60 pip profit targets – nor do they jump in and out of trades because of tiny random moves on 5-minute charts. Large speculators are usually longer-term and trend following in nature. They'll typically look to enter long at a decent price when the market is in an uptrend and then wait for the trend to take their position into profit. Retail traders are essentially betting on a 'reversion to the mean' betting that because the market has just jumped higher it has to now drop lower and vice versa – profits come from trends, not choppy prices. This reason for small retail traders being on the wrong side of the trend is usually well understood.
However, I believe there is another, more important reason why retail traders are usually on the wrong side of the larger underlying trend that's not so well understood. And that reason has to do with the mechanics of the markets themselves. As someone said, to be right is essentially to know what the 'big money' is thinking/doing. This is true because it's the big money, the banks and the large institutions and the traders trading huge accounts that work for them that move the market, NOT the likes of retail Forex. The price will eventually move to where the market collectively thinks it should be (and the market capital is mostly in the hands of the 'big money'). Retail traders usually lose because banks, large speculators and financial institutions usually win. The money doesn't just come from nowhere, one trader's loss is another trader's gain - usually it's a case of many small traders losses are a few large traders gains. Just like in a giant poker game, the money is flowing from the majority of participants to the minority – and it actually has to be like this for the market to work. Small traders being net short during an uptrend and net long during a downtrend comes from the fact that the banks and large institutional traders need a whole lot of smaller traders to take the opposite side of their trades before they can continue to push the market in the direction of the trend; so the market will do whatever it takes to deceive the majority of traders into taking the other side of 'big players' the 'market movers' trades. As Soso said, 'For a market to trend it needs to deceive and shakeout the majority of traders'. At turning points however, retail traders will usually be right. When everyone wants to buy and there is nobody left to sell the big players can't buy more and push the market any higher as there is nobody left to buy from and vice versa – by the time everyone is looking to jump in on the main trend the institutions who got in at the start will take advantage and use the situation to liquidate their positions. Or, as the old contrarian saying goes 'When everyone wants to buy the market must fall as there is nobody left to sell. When everyone wants to sell the market must rise as there is nobody left to buy'.
Conclusion,
My theory is what I think is really happening in the market. And my advice based on this is to forget being glued to the screen reacting to 5-minute charts, jumping in and out of trades like a yoyo. And definitely forget about using 50 pip stop-losses and trying to pick tops and bottoms. I would, in a nutshell, advise doing the following: -
Determine the direction of the long term underlying trend.
Decide what you think is a good and realistic price to get in at, and then wait for the opportunity to enter at that price – if after entering the market goes against you 100 pips or so it's no big deal, it happens, and picking the top or bottom is impossible anyway.
Wait for the market to take your trade into profit and take a profit when it's decent – although you can stick with the trade until the trend turns.
Thanks to everyone at Forex Factory for all their thoughts and advice - if anyone has anything they like to say feel free to leave it on the thread or email me :)
