How To Know If A Forex Trading System Will Make Money
There are many things that you can consider when you are trying to decide whether a forex trading system has a chance of being profitable for you. There are some that you can throw out right away because they clearly have more in common with gambling than serious trading.
For example you should avoid any system that tells you to alter your risk according to whether your previous trade lost or won. This is a plan that some gamblers use to try to change losing systems into winners, and it never works. They just end up losing big time sooner or later. Your risk should be a constant small percentage of your investment fund size, probably around 2%.
One important factor in the success or failure of a forex trading system is the edge. This is a simple mathematical formula that takes the average size of winning trades multiplied by the probability of a win, minus the average size of losing trades multiplied by the probability of a loss. We could write it like this:
Edge = (average win x probability of win) – (average loss x probability of loss)
Take two very different forex trading systems. One of them wins most trades, say 80%, but only wins a small amount each time, say 40 pips. On the other hand the risk is high so when it loses, it loses a lot – say 100 pips. Some day trading systems are set up this way. Here the edge is (40 x 80%) – (100 x 20%) = 12 pips.
The second system has occasional big wins and a lot of small losses. Here you might have an average gain of 200 pips but only 20% of trades are winners. When you lose, you lose an average of 40 pips. So the edge is (200 x 20%) – (40 x 80%). Again it comes out to 12 pips.
Which is the better system? In terms of return on investment, they are both the same. It is other factors that would lead you to choose one or the other. For example, how many trades can you make per week? If one of those systems gives a lot more trading signals, you will end up making your profit more quickly. Another factor is your own peace of mind. Could you really handle a system that made loss after loss … 80% losing trades? Most traders could not, at least when they are starting out.
Edge is a very important factor and you should try to calculate it for every system that you consider or test. With some systems you will be given enough information to work this out from the description of the system, or they may actually tell you what the edge is. However this is not always the case and anyway you will probably want to check this for yourself by testing, either in a demo account or by back testing. Some testing is required for any forex trading system.
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