New traders should have no illusions—online trading involves risks and costs. Anyone looking to try online trading should be fully aware that it requires time dedicated to planning and analysis, and also plenty of thought about costs and risks of losing money. Nearly all traders enter losing trades at one time or another, especially beginners. To make money, traders need to focus on avoiding losing trades and money, and then on maximising their wins and overall earnings.
Decide On A Strategy
There may be several strategies possible for making money in online trading, but traders should have a notion of which strategies they plan to implement before they begin. Much like knowing your route before you travel somewhere from your home, it's helpful for you to choose a route to reach your trading destination before you begin buying and selling securities or other assets.
- Are you going to use a fundamental strategy, analysing economic indicators and news that will support your ideas about a price move?
- Or will you rely purely on technical analysis to get a notion of trends in market movements?
If you choose technical analysis, it's important to know which analytical tools to use and how they work. Another consideration is whether you will be trading intraday or long-term, and also if you will be following trends, or trading on swings within a range.
There are online trading platforms for several different markets and asset classes, including equities, options, futures, commodities and foreign exchange. Regardless of which market, beginning traders may want to start with only one or a small number of assets to avoid becoming overwhelmed.
Money Management: How Much Risk Is Too Much Risk?
One of the key aspects of making money when trading online is discipline, which is especially important when deciding how much money to put into trading. This decision is commonly known as "money management."
One popular rule of thumb for traders is to limit their risk on trades at any given time to no more than 5% of their total account balance. Thus, if a trader has an account balance of US$10,000, they will want to hold their risk to no more than US$500.
This can mean:
- Up to 10 positions worth US$50 each
- Five positions worth US$100
- Two positions worth US$250
- One position worth US$500
The reason for this practice is that even if a trader enters one losing trade, or several losing trades, during a given session, they will still have funding left over in their account in subsequent sessions to make up for the loss and potentially turn a profit.
Practice With Simulation And Backtesting
It may seem obvious to some, but it's recommended that traders practice on a trading simulator before entering live trades. This allows for testing strategies, sharpening skills and avoiding losing money in the market on poorly developed trading ideas. Most brokerages offer trading simulators that can be used for free when opening an account. If possible, traders may want to seek simulators that use real-time market information so that they can test their strategies in real-life market conditions.
Another popular technique for practicing trading strategy is to use "backtesting." Backtesting is testing strategies with historical data to verify whether a particular strategy can be successful. The advantage of backtesting is that by using scenarios that have already occurred, you won't be forced to wait for several scenarios to play out in the live market to verify the consistency of your strategy.
Successful Trades—Or: "Cut Losses Short, Let Profits Run"
As it turns out, the words of famed late 18th century economist and trader David Ricardo—"Cut short your losses; let your profits run on"—have been particularly useful for traders over time, especially in forex markets.
In an FXCM study of 43 million trades, it was revealed that most traders made winning trades but nonetheless lost money when trading. The study showed that the key mistake made by traders was that they were taking the wrong approach to both their winning and losing trades. A majority of traders who lost money on trades consistently exited their winning trades too early for fear of suffering an unexpected negative reversal. They allowed their losing trades to remain open too long under the apparent idea that the market would sooner or later undergo a favourable reversal that would allow them to make up for their losses. Read the full guide.
Both actions are consistent with psychological studies that show that traders fear losses more than they appreciate gains. But from an objective point of view, traders have found more success by staying in the market when they are winning and getting out quickly when they are losing. One way to do this is to use stops and limits to assure a risk-reward ratio of greater than 1:1.
Enhancing Gains With Margin, Leverage
Once traders have a handle on basic trading strategies that can produce profits, they may want to aim to make use of a margin account through which they can amplify their gains. With a sufficient deposit of cash, most brokerages will extend traders margin loans that will give them leverage to multiply the value of their basic investment. Leverage can range from a ratio of 2:1 to up to 400:1 in some cases, meaning gains can be multiplied by those amounts. Traders who use margin need to be aware that losses can be multiplied by the same amounts.
Calculating Costs: Commissions
One of the not-so-hidden costs in trading is commissions. For equities, options and futures, traders may pay a flat fee per trade. In forex trading, commissions are often built straight into the bid-ask spread, so traders will be subject to varying costs with each trade depending on market conditions and the widening and narrowing of spreads.
Once traders have determined their trading strategies and figured out their costs, they will want to consider the impact that taxes could have on their earnings. Traders who can make money on a consistent basis in the market and have found they are dedicating themselves full time to the activity may be able to make use of available tax deductions by claiming trader tax status.
Additionally, they will want to make sure they are reporting their earnings on the correct IRS reporting forms to avoid unnecessary tax losses. The proper status and reporting methods could make a difference of thousands of dollars per year. And because the rules may change from year to year, it's important to discuss trading practices and tax rules with an accountant before going headlong into trading.
Online trading is not always easy and there are no guarantees of profits in all situations. One of the more obvious ways to find success on a more consistent basis is to organise trading activities beforehand and plan strategies for minimising trading losses and additional trading costs, while maximising potential gains.
This will include setting adequate risk-reward ratios through use of stops and limits. Traders will also want to minimise other costs paid, such as commissions, and plan ahead for tax preparation to assure that minimum tax amounts are paid on trading activities.
Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…