Being Right Versus Being Profitable

I recently came across a major study conducted by the Forex broker FXCM.    The study, which examined tens of thousands of real trading accounts and over 12 million individual trades, sheds light on the psyche of the average trader.

After aggregating data on 12 million currency trades, the first conclusion that FXCM came to was that, surprisingly,  the majority of trades are closed out at a profit:

The graph above shows that, for example, 59% of all EUR/USD trades are closed out at a profit.  Does this mean that the Forex market is a mechanism that allows the average trader to consistently profit?

In fact, that is not the case and according to FXCM the vast majority of account holders are consistent losers.   The reason for this is illuminated in the next chart:

The chart above shows that for every single currency pair, the average trade that is closed out at a loss is much larger than the average trade that is closed out at a profit.

For example, the average profitable EUR/USD trade earns 65 pips, but the average EUR/USD loss gives back 127 pips - nearly twice as much.    The average trader, therefore, is a loser, despite winning most of the time.

The reason for this anomaly I think can be found in the field of psychology, in particular work done by psychologist Daniel Kahneman on what is now known as Loss Aversion and the Disposition Effect.

Daniel Kahneman, who recently authored the book Thinking, Fast and Slow, illuminates this idea of loss aversion in the following quote:

There is an asymmetry between gains and losses, and it really is very dramatic and very easy to see. In my classes, I say: ''I'm going to toss a coin, and if it's tails, you lose $10. How much would you have to gain on winning in order for this gamble to be acceptable to you?''
People want more than $20 before it is acceptable. And now I've been doing the same thing with executives or very rich people, asking about tossing a coin and losing $10,000 if it's tails. And they want $20,000 before they'll take the gamble.
So the function for gains and losses is sort of kinked. People really discriminate sharply between gaining and losing and they don't like losing.

Bottom Line:

  • The average trader wants to be right and most traders are right most of the time
  • Despite a high win rate, most traders lose money
  • Most traders lose money because their losses are about twice as large as their winners
  • This can be explained by Daniel Kahneman, who proves that humans find losses about twice as painful as gains feel good. 
  • Trend following traders fight this instinct by strictly cutting losses and letting winners run, thus providing the opposite result of the average trader - they tend to be profitable over time