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High-Probability Techniques for
Trading without Indicators

nak e d
forex
alex nekritin

walter peters , phd

Foreword by Abe Cofnas

Naked Forex

Naked Forex
High-Probability Techniques for
Trading without Indicators

ALEX NEKRITIN
WALTER P ETERS, PhD

For all gun traders as well as those rude and
cute possums of the world.

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Contents

Foreword

ix

Preface

xi

Acknowledgments
PART ONE

xiii

Naked Forex Trading Revealed

CHAPTER 1 The Fundamentals of Forex Trading

3

CHAPTER 2 Avoiding a Trading Tragedy

9

CHAPTER 3 Back-Testing Your System

25

CHAPTER 4 Identifying Support and Resistance
Zones

39

PART TWO

Naked-Trading Methodology

CHAPTER 5 The Last Kiss

73

CHAPTER 6 The Big Shadow

95

CHAPTER 7 Wammies and Moolahs

111

CHAPTER 8 Kangaroo Tails

131

CHAPTER 9 The Big Belt

151

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viii

CONTENTS

CHAPTER 10 The Trendy Kangaroo

163

CHAPTER 11 Exiting the Trade

177

PART THREE

Trading Psychology

CHAPTER 12 The Forex Cycle

203

CHAPTER 13 Creating Your Trading System

209

CHAPTER 14 Becoming an Expert

229

CHAPTER 15 Gaining Confidence

239

CHAPTER 16 Managing Risk

249

About the Trading Software and Video Tutorial

261

About the Authors

263

Index

265

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Foreword

he Internet engendered the online trading phenomenon. One can
trade anywhere there is a connection to the World Wide Web. The result has also been the creation of instant experts, trading gurus who
offer modern versions of snake-oil cures for traders. The web is flooded
with trading alerts, systems, and blogs that promise returns that will lead
to instant wealth. Most of the books in the field fail to provide actionable
knowledge. In this environment, Alex Nekritin and Walter Peters in Naked
Forex: High-Probability Techniques for Trading without Indicators provide an honest and effective presentation about forex trading that certainly
beginners need, and that more experienced traders forget they need.
Naked Forex makes some powerful points about trading forex that really apply to other markets as well. First and foremost, price is the most important indicator of all. All indicators are derived from price. Many traders
have forgotten this fact because computerization has made it easy to generate new indicators. Indicators work more like training wheels for learning
to ride a bicycle. They are temporary in their capacity to help traders build
their skills. They actually limit the evolution of a trader’s performance because they provide a disincentive to “listen” to the market. Naked Forex
goes into detail on how a trading signal that is indicator-based is inferior to
what Nekritin and Peters call a “naked” signal.
Another key insight that the book provides is the importance of knowing one’s personality in trading. Trading systems that are based on untested
algorithms that are purely technical will surely fail. Nekritin and Peters argue that trading systems should reflect decisions that traders would make
that are based on looking at charts. Manual backtesting, they suggest, is an
effective way to identify a trading system’s strengths and weaknesses.
A third major focus of Naked Forex is the concept of identifying support and resistance zones. The fact is that with the trillions of dollars that
float each hour through the currency markets, prices reach certain levels
and stop. One can try to figure out why they stop rising or stop falling. But
the job of the trader is to observe accurately where the price is and where it
came from. Price zones provide the naked truth about market sentiment. If

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FOREWORD

a price breaks through a zone, no matter what the reason, it is a signal—and
a more powerful signal than any indicator. Nekritin and Peters call these
points of price action market scars. It is a good metaphor because markets
have memory and so do traders. The authors introduce the “last-kiss trade”
as a powerful tool in identifying when breakouts have occurred. The book
is filled with gems that provide visualizations of price action, such as the
big shadow, kangaroo tails, and the big belt.
As someone who has been training people on how to trade forex for
nearly 13 years, I welcome this book as one that stands out as a basic manual on how to evaluate and trade the increasingly chaotic forex markets. I
will use it for my students.
Abe Cofnas
author of Trading Binary Options (Bloomberg) and
editor of The Fear and Greed Trader Newsletter,
Agora Financial, Inc.

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Preface

nfortunately, most forex traders lose out. Profitable trading is reserved for the select few. Expectations drive reality for many things
in life, and successful trading is no different. Most forex traders have
three preconceptions about successful trading. These are the three myths
of successful trading, and the structure of this book is based on each of
these myths.
Myth 1: Successful trading must be indicator based. The first part of
this book dispels this myth. There are many ways to profit in forex, some
of them do involve indicators, but indicators are not necessary for successful trading. There are professional traders around the globe, many of
them good friends of mine, who use “naked” charts to make trading decisions. In some ways, indicators delay the progression of the trader because
the focus is on the indicator, rather than price action. Indicators become
the scapegoat for losing streaks and often keep losing traders in a holding pattern. It is much easier for the novice trader to begin trading without
indicators from the beginning.
Myth 2: Successful trading must be complex. The second part of this
book is about naked trading systems. These systems are incredibly simple. Do not confuse simplicity with ineptitude. Although these systems are
simple when applied correctly, they may also yield big profits and build
confidence in your trading. You may view this as the meat of the book, the
most important section, but I disagree. I think the third section is the most
critical to your trading success.
Myth 3: Successful trading is dependent on the trading system. This is
probably the most widely held belief among traders. This is precisely why
there are thousands of trading systems on the market, all promising great
riches to the brave traders who pony up the money for the next Holy Grail.
Many veteran traders understand the importance of trading psychology.
Personal beliefs and attitudes toward risk are the greatest predictors of
trading success, and the trading system is not nearly as important as many
traders assume. For most traders, after years of trading, this fact becomes
apparent. The third section of the book concerns trading psychology and

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PREFACE

how you may both identify and change your thinking, because this is the
real driving factor in your trading success.
Many readers will continue to hold onto these myths. In fact, some
readers (those who believe trading success depends on the trading system)
will simply read the second section and begin trading the naked trading
systems. This is unfortunate. The first section is critical because it offers
reasons for price action trading (a new belief system) and a course of action for becoming an expert at naked trading (new trading habits). The
third section is where breakeven and slightly profitable traders will learn
to move into the realm of the true professional trader. All sections of the
book are important, and it is my hope that by reading it you will find simple
methods for extracting profits from the market.
You can trade successfully without indicators. For many traders,
naked trading is both refreshing and easy to apply. You can trade successfully with simple trading systems. Simple systems are robust and powerful.
However, ultimately, your success as a trader will depend, not on the trading system, but on how you incorporate your beliefs and attitudes about
risk into your trading routine. I hope this book will aid you in your journey
to trading success.
I also hope that you keep in touch by stopping by the companion web site for this book, complete with live market trades, additional
tools, and new naked trading systems. You will find this on the Web at
www.fxjake.com/book.
Walter Peters, PhD
Sydney, Australia
October 2011

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Acknowledgments

here are many people who deserve acknowledgment for this book.
The list includes but is not limited to the following: Meg Freeborn for
patience and unique ability to turn rough stones into polished gems
(I know because I have seen her do it). Eddie Kwong deserves credit for
putting this book idea in front of the right people. Sean Lydiard is living
proof that six degrees of separation is fact. Arshia Bolour, who is a true
brother in every sense of the word. Abe Cofnas, for his patience and kindness in helping me with the conversion from trader to trading author. Evan
Burton for believing in the book idea and making it happen. Colin Jessup
for his unique perspective on naked trading. My brother Ashkan Bolour,
who introduced me to the world of forex so many years ago. My parents
for unconditionally supporting me in every endeavor. My dissertation committee (and Dr. David Estes in particular) who taught me years ago how to
write so that others could understand me. My sister for always being there
for me. And to the first-line editor Melissa McConaghy—without your help,
I am certain this book would not have happened.

T

—W.P.

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PART ONE

Naked Forex
Trading Revealed

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CHAPTER 1

The
Fundamentals of
Forex Trading
Gregory: “Draw thy tool . . .”
Sampson: “My naked weapon is out.”
—Shakespeare, Romeo and Juliet

elcome to the world of forex trading. Forex is the largest market
in the world. Forex traders exchange $4 trillion each day, but is
forex the best market for you? The answer depends on what you
are looking for. If you want a market that never sleeps, if you want the
opportunity to trade at any time of the day, if you would like to make a
boatload of money in a short amount of time, forex may be for you (it
should be noted that you may also lose an incredible amount of money in
a short amount of time). Traders with very little money can begin trading
forex. In forex, you may take relatively large trades with small amounts
of money because of the favorable leverage requirements. There are many
reasons to become a forex trader, but before jumping into the reasons,
perhaps we should take a closer look at the characteristics of a forex trade.

W

A QUICK LESSON IN CURRENCIES
“Forex” is simply an abbreviation for “foreign exchange.” All foreign exchange transactions involve two currencies. If an individual trader, a bank,
a government, a corporation, or a tourist in a Hawaiian print shirt on
a tropical island decides to exchange one currency for another, a forex
trade takes place. In every instance, one currency is being bought and,
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NAKED FOREX

simultaneously, another currency is being sold. Currencies must be compared to something else in order to establish value; this is why forex trading
involves two currencies.
If you and I go to the beach and I tell you the tide is low right now,
how do you know this is true? You may decide to compare the current
water level to the pier. If there are starfish and mussels exposed on the
pier, you may believe me because you can compare the current water level
to the previous water level. In forex, we compare currencies in much the
same way, currencies are traded in pairs and, thus, one currency is always
compared to another currency.
An example may be helpful to illustrate how currencies are traded. If
you are a hotshot forex trader, and you believe that the EUR/USD is going
to go up, you may decide to buy the EUR/USD. Thus, you think that the
Euro currency will get stronger, and the U.S. dollar will weaken. You are
buying the EUR/USD currency pair, another way to look at this is to say
you are buying Euros and simultaneously selling U.S. dollars. The unique
(and often difficult to understand) aspect of forex trading to keep in mind
is this: Each forex transaction involves the buying of one currency pair and
simultaneously the selling of another currency pair.
If you have experience buying or selling in any market—the stock market, a futures market, an options market, the baseball card market, or the
used car market—then you understand markets. For any market transaction a buyer wants to buy something and a seller wants to get rid of something. The forex market is simply a money market, the place where speculators exchange one currency for another. In many ways, the forex market is
no different from the stock market. The major differences between forex
and the stock market are as follows: A forex transaction involves buying
one currency pair and selling another, also, the symbols to identify forex
pairs are consistent and systematic, unlike the symbols used to identify
companies listed on a stock exchange.
Forex traders buy and sell countries. It is true: Forex traders are basically buying “shares” in a country, just as a stock trader buys shares
in a company. For example, if forex trader Emma decides to sell the
EUR/USD, she is essentially selling the European Union (and buying the
United States). To be even more specific, we might suggest Emma is buying
the economy of the United States, and selling the economy of the European
Union. Does this mean that Emma must keep tabs on all the economic data
for all the countries that she is trading? The short answer is no, but we will
talk more about news and trading based on economic news and data a bit
further on in this book.
Just as a stock has a symbol, so do currencies. Table 1.1 illustrates the
most popular currencies and their symbols. Do you notice a pattern? There
is a secret code for currencies. The three-letter code for each currency pair
is composed of the country (first two letters) and the name of the currency

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5

The Fundamentals of Forex Trading

TABLE 1.1 Major Currencies of the World
Country

Currency

Symbol

Nickname

Euro Zone
United States
Japan
Great Britain
Switzerland
Australia
New Zealand

Euro
Dollar
Yen
Pound
Franc
Dollar
Dollar

EUR
USD
JPY
GBP
CHF
AUD
NZD

Fiber
Greenback
Yen
Cable
Swissy
Aussie
Kiwi

(last letter). So, for example, the Japanese yen is JPY, the “JP” stands for
Japan, and the “Y” stands for Yen. The currencies listed in Table 1.1 are the
major currencies; these are the most widely traded currencies.

PLAYERS OF THE FOREX MARKET
The forex market is an enormous, growing market. Forex trading doubled
from 2004 to 2010, and today the amount of money traded in forex each day
is staggering. The New York Stock Exchange, the world’s largest stock market, turns over about $75 billion each day. Forex traders trade five times
that amount each day.
You often hear people claim that because the forex market is so large,
it is relatively easy for forex traders to jump in and ride the trends in this
gigantic market, the world’s largest market. However, most forex traders
trade what is called the retail forex market; this is a different market (akin
to a parallel universe) to the “real” forex market in which $4 trillion is exchanged each day. In essence, there are two markets in forex. There is
the interbank market, where banks, hedge funds, governments, and corporations exchange currencies, and there is the retail market. Most forex
traders trade in the retail forex market, an entirely different market to the
“real” interbank market.
In the retail forex market, your competition is the other forex traders
trading the retail forex market, and, believe it or not, your broker. When
you make money trading forex, these other traders in the retail market lose,
and so does your broker. Most retail forex traders do not make money. In
fact, your forex broker will assume that you are going to lose money in the
long run. This is a perfectly reasonable assumption, since the large majority
of forex traders lose money.
Would you like to know about the secret that forex brokers don’t want
you to know? Here it is: Forex brokers divide all traders into two groups.
There are the winners—these are the forex traders who make money—and

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NAKED FOREX

then there are the losers—these are the forex traders who lose money.
Guess which group all new forex traders get put into? Retail forex brokers
believe that all new customers are unlikely to make money, so all new accounts are placed into the loser group. After several months of consistently
profitable Forex trading a trader may be placed into the winner group.
It may sound surprising, but it is true. If you start making money trading forex over several months, you will join the winners. Your retail forex
broker will begin to hedge your trades. In other words, if you are in the
winner group, your retail forex broker will take trades in the real forex
market, the interbank market, to offset the profits accumulated by the winner group. For example, if most of the traders in the winner group have
decided to buy the EUR/USD, then the broker will put in a trade to buy the
EUR/USD in the interbank market in the hopes that, if the winners are correct, the forex broker can use the profits in the interbank market to pay the
winning traders. This is how your retail forex broker deals with winning
traders.
What about losing traders? Since most forex traders are losing traders,
your forex broker assumes that you will not make money when you open
up an account. Only after you have consistently made money trading forex
will your broker become concerned with your trading. Guess what happens to all of those losing trades? Those losing trades fatten your broker’s
pocket. All losing trades are “business profits” for your broker. This is because your broker takes the other side of your forex trade. Although it is
true that some retail forex brokers match up trade orders so that a trader
with a buy trade order is paired up with a trader with a sell trade. However, the overwhelming majority of retail forex brokers do not do this.
Unless you are a consistently winning trader, your broker will take the
risk on your trades, and assume that your trades will lose money in the
long run. This is not something that is widely discussed, but it is true.
Your forex broker wants you to lose, because your losses are your broker’s
profits.
How would you like to make the jump from the group of losing traders
to the group of winning traders? Would you like to join the 5 percent of
winning traders? I know you can join the 5 percent, and I will show you
precisely how you can leap into the group of winners in later chapters.

TOOLS OF THE TRADE: FUNDAMENTAL
VERSUS TECHNICAL INDICATORS
So, how do forex traders decide when to buy or sell? There are basically
two schools of traders, and you must decide which school fits your trading

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The Fundamentals of Forex Trading

7

personality. The first school is the school of fundamental analysis. Fundamental traders use economic reports and news reports as the basis for
their trading decisions. Forex traders who have a fundamental approach
will closely examine world events, interest-rate decisions, and political
news. Fundamental traders are concerned with properly interpreting news,
whereas the focus for the technical forex trader is quite different.
The technical forex trader uses technical indicators (or “indicators”) to
properly interpret price movement on a chart. The forex trader who adopts
a technical, indicator-based approach will examine the price charts. So,
while the fundamental forex trader is concerned with interpreting news
and world events, the technical trader is concerned with interpreting price
on a chart.
What are technical indicators? Indicators are simply another way
of looking at a market price. In much the same way that it is possible
to examine the speed of a car in many different ways, it is possible to
examine price charts in many different ways, with indicators. Just for a
moment, consider how many different ways you may measure the speed of
a car:

r
r
r
r
r

Measured in kilometers per hour.
Measured in miles per hour.
Measured in the time it takes to travel one mile.
Measured by the time it takes to accelerate to 60 mph.
Measured by how quickly the car can stop.

Likewise, there are many ways to look at price on a chart. There are
more technical indicators than telephone call centers in India.

WHAT IS NAKED FOREX?
It can be very confusing for the novice trader, and this is one reason
why naked trading, trading without indicators, can be liberating. When
starting out, many traders focus on the indicator. This is completely
understandable since nearly 90 percent of the forex trading books, the vast
majority of forex sites on the Internet, and forex trading seminars focus
on indicators and indicator-based trading.
Indicators encourage “secondary thinking,” which is a real handicap
for traders looking to acquire expertise. Secondary thinking involves analyzing the indicator, spending time considering where the indicator may
go, rather than focusing on the market. Naked traders, by definition, focus
on the market, which is very different.

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NAKED FOREX

Focusing on indicators may be one of the primary reasons that some
forex traders do not make money. Indicators can be confusing, unhelpful,
and just plain wrong. In the next chapter we take a look at technical trading, and some of the tragic trading mistakes forex traders make, and how
to avoid them by adopting the naked-trading approach.

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CHAPTER 2

Avoiding a
Trading Tragedy

Out of intense complexities intense simplicities
emerge.
—Winston Churchill

f you are reading this book, you are probably a technical trader. You
may have spent time, money, and effort learning about indicators. You
may have learned through experience that trading with indicators can
be very difficult. In some ways, trading with indicators makes it difficult to
find profits. Perhaps a close look at why indicator-based trading systems
have difficulty finding profits in forex is in order.
All indicators are created from price data. This is what all indicators do
to price data: Price data enters into an equation and is spit out as something
else. Sometimes the end product is a squiggly line, sometimes a straight
line, sometimes a color or a number; it depends on the indicator. The end
result is always the same: The indicator changes price data via a formula.
The form of this end result (the indicator) may vary, but the process is
always the same.
These very same indicators, based on price data, are meant to hint at
future movements in the market. Stated another way, an indicator will suck
in price data, massage and process these data, and then spit out a graphical
representation of these data. Indicators offer price data in another form.
Perhaps this new form of price data is easier to interpret; perhaps this new
form of the price data will hint at what the market may do in the near future. All indicator-based trading systems are founded on the idea that price
data is in a better form when presented as an indicator. Trade decisions

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NAKED FOREX

based on indicators assume that the data in indicator form is more valuable than raw price data.
INDICATOR
A metric derived from price data. Historical price data—such as the open, close,
high, and low—are entered into a formula to calculate the metric. This metric
is then represented graphically to anticipate and interpret market movements.

Traders want to know where price will go in the future. Traders pay
millions upon millions of dollars for educational seminars, DVDs, website
lessons and, yes, even books such as this one. The great hope for most
traders is that there is a valuable indicator (or recipe of indicators) that
will hint at where the market is headed in the future. Millions upon millions
of dollars are spent each year by traders (and also investment companies,
hedge funds, banks, etc.) because a slight edge may provide millions of dollars in profits. In forex a slight edge may mean billions of dollars in profits.

IS THERE A “BETTER” INDICATOR?
Which indicator is best? Which suite of indicators offers a clear edge in the
markets? Perhaps it is best to find out who is making money in forex, and
then do what they do. Which is the magic formula? Unfortunately, the answer to this question is “It depends on who you ask.” This may very well
be the correct answer. As we will see later in the book, trading is often
relative and rarely, if ever, a one-size-fits-all endeavor. Some indicators are
considered shams, others are misinterpreted by the masses, and still others are best used contrary to their original design intent. Indicators may
be incorrect. What if the indicator is correct, but a bit slow to hint at the
direction the market will take? The indicator might provide valuable information, but might also be slow to the party, and thus not of much value.
Perhaps a slight change to the indicator formula will speed it up a bit.
Perhaps indicators are similar to a wristwatch, constantly improving,
more features available as needed, but would it be possible to take a wristwatch, and manipulate time by running a formula through the hours, the
minutes, and the seconds displayed on the wristwatch? Would the wristwatch keep better time once the formula manipulated the actual time of
the day?
Using a formula to create a better time on a wristwatch may seem
weird and counterproductive, but this is precisely what indicators may

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11

accomplish by changing and massaging price data. Indicator-based trading is taking a wristwatch and changing the time with a complex formula
in the hopes that the wristwatch will somehow tell time better. Who wants
a wristwatch with something other than the real time displayed? Do indicators (all of which are calculated using price data) allow us to understand
price better?
Perhaps it is best to put aside any philosophical differences with technical indicators. Let us assume that our indicator is based upon a magical
formula and this formula allows us to get a glimpse of the future. Our indicator magically transforms price data into some other number, color, or
line, and suggests where price is headed in the near future. Unfortunately,
even if our indicator is able to accomplish this, difficulties may endure
with indicator-based trading.
Indicators are inherently slow. The market will be moving up long before an indicator suggests it is time to buy. Likewise, an indicator will suggest it is time to sell long after the market has started falling. This is one
of the main complaints with indicators: they lag behind price. This is a fair
concern. Figure 2.1 contains an AUD/USD four-hour chart with the Relative
Strength Index (RSI) indicator. Traditionally, there are two RSI signals. If
the RSI is above the 70 level, the market is overbought, and once the RSI
falls back down below 70, a sell trade is initiated.
Likewise, if the RSI falls below 30, the market is said to be oversold,
and, traditionally, a buy trade is signaled once the RSI moves back above
30 (see arrow in Figure 2.2).
In these examples we see that the RSI indicator suggests a trade at
about the right time. The market turned around near the RSI signal in both
examples. However, the RSI did not signal a trade at the precise turning
point in the market. To find these turning points, an indicator of a different
type is required. One of the primary reasons why naked trading is so attractive to forex traders is because naked trading allows for early entries into
trades. Indicators may alert traders to the fact that the market has turned
around after the market has turned around, but naked traders may find
turning points in the market as they occur. Naked trading strategies are
based on the current price of the market, and, therefore, they allow for an
earlier entry. Indicator-based trade signals will lag because it takes time
for the price data to be processed through the formulas that make up the
indicator.
INDICATOR LAG
Significant moves in the forex market occur before a technical indicator provides
a signal.

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NAKED FOREX

0.98400
0.98020
0.97650
0.97280
0.96910
0.96540
0.96160
0.95790
0.95420

Relative Strength Indicator
Sell Signal

Relative Strength Indicator

0.95050
0.94680
100

70

30

0
08:00

9 Jul 00:00 9 Jul 16:00 10 Jul 08:00 11 Jul 00:00 11 Jul 16:00 14 Jul 08:00 15 Jul 00:00 15 Jul 16:00 16 Jul 08:00 17 Jul 00:00 17 Jul 16:00

FIGURE 2.1 Traditional RSI Sell Signal on AUD/USD 4-Hour Chart.
© 2000–2011, MetaQuotes Software Corp.

Naked traders have an incredible advantage. Entering a trade early often means the entry price is closer to the stop loss price. A tighter stop loss
may mean more profits, the precise reason for this is examined later in the
book. After mastering a few simple strategies, naked traders find it very
difficult to move back to indicator-based strategies simply because nakedtrading strategies remove the lag time that is inherent with indicator-based
trading.
Here is another example, this time with the EUR/USD daily chart (Figure 2.3). In this example the indicator at the bottom of the chart is the
Moving Average Convergence Divergence (MACD). The construction and
theory behind the MACD is not important, the MACD consists of a few
moving averages. The critical signal for the MACD is when the two moving
averages cross (see the dark circle in Figure 2.3). A traditional buy signal

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Avoiding a Trading Tragedy

0.79385
0.79120
0.78855
0.78590
0.78320
0.78055
0.77790
0.77525
0.77260
0.76995
0.76730
100

Relative Strength Indicator
70

30

Relative Strength
Buy Signal
0
Feb 00:00 26 Feb 16:00 27 Feb 08:00 28 Feb 00:00 28 Feb 16:00 1 Mar 08:00

2 Mar 00:00

2 Mar 16:00 5 Mar 08:00 6 Mar 00:00

6 Mar 16:00 7 Mar 08:00

8 Mar 00:00

8 Mar 16:00

9 Mar 08:00

FIGURE 2.2 Traditional RSI Buy Signal on AUD/USD 4-Hour Chart.
© 2000–2011, MetaQuotes Software Corp.

occurs when the MACD has been traveling lower for some time and then
turns around, and the faster-moving average crosses the slower-moving
average.
In Figure 2.3 the EUR/USD daily chart has been falling for some time.
Price starts to turn around and trade higher, and consequently the MACD
moving averages start to creep upward. Finally, we see the faster-moving
average on the MACD has crossed above the slower-moving average. This
signals a buy trade for the MACD trader. After crossing upward on the
MACD, the market does indeed move higher (see Figure 2.4).
Although this trade looks like a nice trade, the naked trader would
have entered this trade earlier than the trader using the traditional MACD
trading strategy. The naked trader and the MACD trader both profit, but the
naked trader is able to enter the trade sooner and use a tighter stop loss.

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1.49405
1.47005
1.46350
1.44605
1.42130
1.39730
1.37330
1.34855
1.32455
1.30055
1.27580
1.25180
1.22780
0.0145
0.00

MACD Buy Signal
MACD
17 Sep 2008 23 Sep 2008 29 Sep 2008

–0.0441

3 Oct 2008

9 Oct 2008

15 Oct 2008

21 Oct 2008

27 Oct 2008

31 Oct 2008

6 Nov 2008

FIGURE 2.3 Traditional MACD Buy Signal on EUR/USD Daily Chart marked with a
circle.
© 2000–2011, MetaQuotes Software Corp.

Tighter stops mean more money. The naked trader and the MACD trader
could have both exited at the same price, but the naked trader captures
more profits because the stop loss is placed closer to the entry price.
The money-management section of this book will have more information
on how naked trading strategies enable traders to make more money
simply because naked signals appear earlier than indicator-based trading
signals.
The MACD and the RSI are not the only indicators that lag. All
indicators lag. The stochastic is a popular indicator used to time trades
according to the natural rhythms of the market. One traditional stochastic
trading method is similar to the RSI strategy. A sell signal is indicated
when the stochastic falls below the 30 level and then crosses higher (see
Figure 2.5).

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1.48095
1.45290
1.42485
1.39680
1.36875
1.34070
1.31265
1.28460
1.25655
1.22850
0.0342

MACD

0.00

MACD Buy Signal

–0.045
Oct 2008 10 Oct 2008 16 Oct 2008 22 Oct 2008 28 Oct 2008 3 Nov 2008 7 Nov 2008 13 Nov 2008 19 Nov 2008 25 Nov 2008 1 Dec 2008 5 Dec 2008 11 Dec 2008 17 Dec 2008

FIGURE 2.4 The EUR/USD trades higher after the traditional MACD Buy Signal on
EUR/USD Daily Chart.
© 2000–2011, MetaQuotes Software Corp.

PIPS
A “pip” is a percentage in point. One pip is equal to 1/100th of 1 percent.
It has traditionally marked the smallest move a forex pair can make. Forex
traders track trades in terms of pips. However, many brokers are now using
“pipettes”—these are 1/1000th of 1 percent units.

The EUR/USD 1-hour chart shows the stochastic falling below 30 on
the stochastic. A few hours later, the stochastic crosses upward and rises
above 30, a clear buy signal. The stochastic is moving up, so price should
follow. However, the market then falls a further 90 pips. For most traders

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1.47795
1.47650
1.47505
1.47360
1.47220
1.47075
1.46930
1.46785
1.46640
1.46495
1.46350
1.46205
1.46060
1.45915
1.45775
1.45630
1.45485
1.45340
1.45195
100

Stochastic

70

30

Stochastic Buy Signal
0
Dec 14:00 4 Dec 18:00 4 Dec 22:00 5 Dec 02:00 5 Dec 07:00 5 Dec 11:00 5 Dec 15:00 5 Dec 19:00 5 Dec 23:00 6 Dec 03:00 6 Dec 07:00 6 Dec 11:00 6 Dec 15:00 6 Dec 19:00 6 Dec 23:00

FIGURE 2.5 EUR/USD 1-Hour Chart—Traditional Buy Signal on the Oversold
Stochastic.
© 2000–2011, MetaQuotes Software Corp.

this trade would be a big loser. What about the naked trader? In this instance, the naked trader gets a very clear buy signal after the stochastic
buy signal (see Figure 2.6).
What happens after the naked trading signal? The market jumps more
than 40 pips immediately. The naked trader avoids many losing trades by
waiting for a price action signal and quickly finds profits. Not all naked
trades are winners, of course, but this trade is an example of how the naked
trader is able to avoid some of the very common indicator-based mistakes
because the naked trader uses the price action of the market to determine
entry signals.
Notice how the naked trader avoids the drawdown with this trade
signal. The market immediately moves in the expected direction, upward,
after the signal. Contrast this entry to the stochastic entry signal. The

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Stochastic

Naked Buy Signal

Stochastic Buy Signal

FIGURE 2.6 EUR/USD 1-Hour Chart—Naked Buy Signal versus Stochastic Buy Signal. The traditional stochastic buy signal occurs immediately before the market falls.
The naked trader has a buy signal at the market turning point.
© 2000–2011, MetaQuotes Software Corp.

characteristic indicator lag associated with the stochastic means that the
stochastic trader not only enters a losing trade, but immediately after
the stochastic signal the market trades in the wrong direction, and the
trade enters into a protracted drawdown. In fact, it is unlikely that the
stochastic trader ever had profit on this trade. Naked-trading strategies
enable the trader to enter a trade based on current market price action,
and often avoid the severe drawdowns associated with indicator-based
trading.
Most traders believe severe drawdowns are a part of trading. This is
simply not true. Severe drawdowns are characteristic of mistimed entry signals, and most traders use indicators to find entry signals, so most
traders mistime entries.

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TAKING RESPONSIBILITY
FOR LOSING TRADES
All traders experience drawdowns. All traders experience losing trades.
However, naked traders take responsibility for losing trades. Indicatorbased traders often blame their indicators for unsuccessful trades (e.g.,
“the MACD looked like it was going to cross here,” “my indicator did not
load correctly,” “maybe I should change the settings on my indicator because the market has been choppy lately,” “that moving average crossover
was a fake out—whipsawed on that one,” etc.), but the naked trader does
not have this excuse. There is no scapegoat when you are using market
data (price action) to take trades. Trading with price action, that is, the actual price on the chart as the basis for all trading decisions, means that the
naked trader has no excuse for losing trades. This is extremely liberating
for many traders.
The indicator-based trader also has the added advantage of an indicator to blame when things go awry; the naked trader can blame no one
but the market for losing trades. This is a subtle but very important difference point of reference for the naked trader. All trading involves an aspect of luck. All traders experience a lucky streak of winning trades and
an unlucky streak of losing trades. Without the crutch of indicators, naked
traders are more likely to take responsibility for their trading results.
Perhaps we should take a close look at this idea of trading responsibility. If you decide to trade a new trading system, you may have put the system through a screening process. After spending time testing the system,
you have convinced yourself that the trading system is worthwhile and will
indeed make money over the long run (at this stage your research may far
exceed the effort that 90 percent of forex traders put into their trading research). If, after all of your research, when you start trading live you see
the first seven trades turn out to be losing trades, you may be discouraged.
What would you do? Perhaps you decide to maintain trading the system,
and you suffer through an additional three more losing trades. After 10
consecutive losing trades what would you do? Would you stop trading the
system? Would you create a new rule to filter out some of losing trades that
you have experienced? Would you decide the trading system is no longer
profitable, and give up on trading the system? There are many possible explanations for the reason why the trading system failed after you launched
it into live action. Maybe the market has changed. Maybe the system no
longer works. Perhaps the 10 losing trades were just an unlucky streak.
Your decision, after faced with the 10 losing trades, will place you into
one of two groups: the terrible-system group or the bad-market group (only
naked traders can avoid these groups). If you are unsure about your group,

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pay attention to what you think about the next time you have a string of
losing trades, you will quickly learn which group is yours.
Terrible-system traders, after a string of 10 losing trades, blame the
trading system. Terrible-system traders will say “the trading system is not
working anymore” or “this trading system must be modified to get it back
on track.” Terrible-system traders decide to modify or give up on the trading system after a losing streak. Often, terrible-system traders will suggest
adding another indicator or otherwise slightly modifing the trading system
to help filter out some of the losing trades recently triggered. The other
strategy employed by these traders is to give up on the trading system.
“The system is broken,” they say, or “This trading system worked well before, but now it is breaking down, all systems have a shelf life, and this
trading system has expired,” or “the system may have made good profits in
the past, but it simply doesn’t work anymore.”
If you find yourself saying something similar, you are probably a
terrible-system trader. If you are constantly changing trading systems, particularly after a losing streak, you are a terrible-system trader. All terriblesystem traders blame the system when finding profits becomes difficult.
Bad-market traders take a different approach. Bad-market traders analyze the losing trades after a drawdown and instead conclude that the
market has changed. Bad-market traders can come up with many reasons
that this market is structurally very different from before, and may be
heard muttering things like “the Bank of Japan’s intervention has changed
the market,” or “things have changed with the Euro since Spain went
bankrupt.” The precise reasons may vary, but the essence of the argument
remains the same. Sometimes the bad-market trader will use subtle arguments such “the market is too volatile,” “there is not enough volume today,”
“my broker is unable to execute my trades fast enough.” The latter argument hints at a common scapegoat for the bad-market trader—the broker.
Bad-market traders are often identified by their willingness to engage
in broker conspiracy theories. The fact is that dishonest brokers are found
out, and forex traders will eventually abandon the dishonest brokers. Word
spreads quickly, particularly among intelligent, Internet-savvy traders with
high-speed Internet connections. But for the bad-market trader, the broker
offers the perfect excuse for a failing trading system. Bad-market traders
place blame on the broker or the market, and thus have a reason for abandoning a losing trading system.
Many bad-market traders engage in fundamental analysis, but not all
fundamental traders belong to the bad-market camp. The interpretation of
economic data and engaging in fundamental analysis is often an opportunity for bad-market traders to further their argument. These traders will
decide to give up on a trading system after a series of losing trades, just as
the terrible-system traders decide to abandon a losing system; it is only the

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reason for giving up on the system that varies. The terrible-system trader
places blame on the system, and the bad-market trader is convinced the
market has fundamentally changed. Both bad-market traders and terriblesystem traders will end up searching for an entirely different trading
system.
Interestingly, the difference between a terrible-system trader and a
bad-market trader is often conscientiousness. The conscientious trader is
usually the bad-market trader. This is because the conscientious trader will
spend time testing and ensuring that any trading system employed is viable
before risking money in the market. The end result of the system testing
is confidence in the system for the bad-market trader. For the bad-market
trader, the experience of a drawdown is quite harrowing and unexpected,
because the trading system has been tested and seems viable; if the system
cannot be wrong, the market must be “wrong.”
Our terrible-system trader is unlikely to have spent the same effort testing the trading system. The terrible-system trader probably found the system on a forex Internet forum, purchased it from an Internet marketer,
learned it from a friend, or perhaps heard a circle of forex traders discussing the system in hushed tones at a party. The terrible-system trader
may be trading a profitable system, but without spending the time testing
the system, the terrible-system trader is unlikely to hold the system in high
regard.
So how might you avoid falling into the terrible system or bad-market
groups? What might you do to change your fate? You may want to carefully
consider adopting naked trading. Trading naked means trading without indicators, and removing indicators from your chart will make it difficult to
adopt the attitude of the terrible-system trader. Also, if you decide to trade
naked you will be trading on price action or the market movements. You
could blame the market for a string of losing trades as a naked trader, but
that would be a bit like blaming the river for being wet.
Naked traders find trades based on market movements, so, unless the
market is moving “incorrectly,” there is no such thing as a bad market for
the naked trader. Naked traders may only blame losing trades on poor execution (the trader’s fault) or poor luck (sometimes you flip a coin seven
times and it lands on tails every time). Naked traders may find that trading
without indicators is extremely liberating.
Traders around the world have found that adopting naked-trading
strategies means letting go of a trade. There are no indicators to give false
signals, there are no settings to tweak; there is simply the market price
and the trading decision. Naked traders have a true advantage because the
focus of the trade is the current market price. There is no better indicator
of the sentiment, attitude, or exuberance of the market than the current
market price. Naked traders make the current market price their indicator.

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In fact, for many naked traders, the current market price is a bit like a
biofeedback machine. I certainly look at the market price as biofeedback.
A biofeedback machine will allow you to tune into the physiological
changes in your body, in the hopes that you can better control your
physiology. For example, if I am an anxious person, and I am always
suffering from stress, I can hook myself up to a biofeedback machine. The
machine will alert me if I become anxious (blood pressure increases, heart
rate increases, etc. would cause the machine to produce the sound) by
sounding off an alert. I can then pay attention to the sounds of the machine
and use relaxation techniques to decrease my anxiety. The machine simply
alerts me when I need to recalibrate my physiology. Over time, I should
be able to wean myself off of the biofeedback machine and reduce my
anxiety on my own, without the aid of the biofeedback alerts.

LEARNING FROM MARKET
BIOFEEDBACK TM
It may seem strange, but you will eventually be able to do the same thing
with your trades if you decide to adopt naked-trading strategies. In the beginning, the market price is your biofeedback machine. If the market is
going in the wrong direction, you have valuable feedback on your trade.
Learn from this. Was the entry too early? (Most traders I know are much
more likely to jump into a trade too early than to wait too late.) Was the
entry too late? The market will tell you how your trade rates. Why is it
important to pay attention to the market biofeedback? Because you will
learn more from Market Biofeedback than you will learn from any guru,
any trading book, or any online course. Another way to state this is as follows: Paying close attention to how the market behaves after you enter a
trade is one of the best learning tools available to you.

MARKET BIOFEEDBACK
A psychological, behavioral, and trading response to the market price after a
trade has been entered.

Market Biofeedback involves two distinct domains, The first is how
the market reacts (price action) after you enter your trade, and the second is how you react to the price action in the market after you enter
your trade. Both parts of the Market Biofeedback equation are needed for

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you to get a clear picture of what you are learning, and more importantly,
what you should learn, from your trading experiences. You should learn
from the price action the market offers after you enter a trade. You should
also learn from your reaction to the market after you enter a trade. Even
if you do not consciously intend to learn from Market Biofeedback, it is
important for you to recognize that Market Biofeedback will yield all your
important trading decisions. How you approach your trading, which trading systems you employ, whether you give up on your trading or go on to
a long and successful trading career, all these things are determined by
Market Biofeedback.
Most traders allow Market Biofeedback to completely dictate their
trading approach, even without realizing this is happening. For example,
some traders start out trading the five-minute charts and then slowly gravitate toward longer timeframes, such as the four-hour or daily charts. Why
do these traders do this? The answer is Market Biofeedback. Other traders,
after several losing trades, will give up on a trading system and search for
a new one. This change in trading strategy is, once again, due to Market
Biofeedback. Other traders may trade the exact same trading system and
will experience seven losing trades in succession and hold steady, knowing
that the current drawdown is simply an aberration. Market Biofeedback is
the difference between the traders who give up on a trading system and
look for a new strategy and those traders who maintain confidence despite
the losing streak.
How you react and respond to a drawdown, to a windfall of pips,
or something in between is exceptionally valuable information. The easiest way to see Market Biofeedback is to record your thoughts as you
trade. You can record your voice before, during, and after a trade. You
can take screenshots of the trade before, during, and after. You may also
record video of the trade before, during, and after with a desktop-computer
recording software.
Here are the important questions to answer as you record Market
Biofeedback:

r
r
r
r
r
r

Where has the market moved since I entered my trade?
If I looked at the market now, would I take the same trade?
How do I feel about my trade?
What do I like about this trade now?
What do I dislike about this trade now?
On a scale of 1 (poor decision) to 10 (great decision), where would I
rank this trade now?
r If I were not in a trade now, would I take the opposite trade?
If you ask yourself these questions and record your answers before,
during, and after the trade, you will have built up a database of your

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personal Market Biofeedback—an invaluable tool. More importantly, you
will bring into conscious awareness how you react to the market. Most
traders will trade their whole lives without recognizing that Market
Biofeedback dictates how they adapt and change as a trader. By simply
acknowledging Market Biofeedback, you can understand how you react to
the market in general, and how your trades, in particular, mold your approach to trading. Market Biofeedback is the one area that most traders
neglect, most traders are not quite aware of this process. By paying attention to Market Biofeedback over time, you will be able to become aware of,
and eventually control your trading behaviors. This will allow you to take
a big step towards consistent profits.
If you would like to learn more about Market Biofeedback, please go
to www.marketbiofeedback.com.

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CHAPTER 3

Back-Testing
Your System

You need to continue to gain expertise, but avoid
thinking like an expert.
—Denis Waitley

he consistently profitable forex trader is an expert. Just as an expert
farmer understands seeds and soil, and the expert mechanic can hear
the difference between a blown gasket and loose muffler, the expert
forex trader knows markets. Where does this expertise come from? How
does the novice forex trader become an expert? This is the million-dollar
question.
Make no mistake about it, when you step into any market, including the
forex market, and decide that you want to make money, you have decided
you will outwit and outperform some of the most determined, intelligent,
and well-resourced people in the world. All these impressive people have
one goal: to take your money. How can you make money in the markets,
knowing whom you are up against? The answer is simple. Perhaps the answer is much simpler that you would believe.
You must practice.
Practice your craft. Practice your trading. This is the simple way to
become an expert. Simple does not mean easy, because many traders expect to become experts without practice, and sadly they never achieve expertise. Consistently profitable trading is yours if you practice trading and
become an expert.
You now have the secret formula to achieve consistently profitable
trading. Will you use this secret? The best estimates suggest as many as
74.8 percent of traders do not use the secret. This is because 74.8 percent

T

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of forex traders do not consistently make money trading (Forex Magnates U.S. Forex Brokers Profitability Report for Quarter 2, 2011). The
25.2 percent of consistently profitable traders practice trading to get better
at it.
Only 25.2 percent of all of the traders reading this will decide to practice trading to become an expert. It is no coincidence that about 25.2 percent of all traders are consistently profitable. Practice helps achieve expertise in nearly every sport and vocation. It is interesting to see how the
vast majority of aspiring traders expect to immediately become successful
without putting the effort into becoming an expert.
Expert traders put the effort into becoming an expert. It is ironic that
many traders are attracted to the trading lifestyle, thinking that trading will
allow passive income to accumulate. This is certainly true, any trader can
make money while sleeping, but expert traders are much more likely to
achieve consistent, passive income from trading. Trading is like any other
job: Practice and effort must be well-placed in order to reap the rewards.
The expert trader may be able to quickly make trading decisions and place
trades, but these decisions are the fruits of many hours of practice, in
nearly every instance. Traders must earn their pips through practice.
Practice means confidence. Practicing your trading system will enable
you to keep trading your system, and avoid all distractions and excuses
(e.g., terrible-system traders and bad-market traders) along the way. Practicing your trading system will allow you to enjoy the confidence of knowing when you place a trade how likely you are to be successful with that
particular trade.
Would you enjoy trading more if you had a quiet, unshakable confidence in your trading system? Would you find it easier to walk away from
your computer if you knew the precise likelihood that your trade would
be a winner? Would it be nice to know that you will avoid the excuses
bad-market traders and terrible-system traders make? What would happen
if, from today onward, you maintained confidence in your ability to extract
profits from the market even through the ups and downs that are inevitable
in any trader’s life?
Consistently profitable traders, otherwise known as expert traders,
have one thing in common: They test their trading systems. These traders
practice their trading systems. There are many methods for testing a trading system. Each of them has advantages and disadvantages.
Depending on your personality and how you approach your trading,
one of these approaches is likely to resonate with you more than the others.
Decide which of the three methods you will adopt to become an expert
trader.
Each of these methods are back-testing methods. Back-testing is a
common term used in trading that simply means “testing a trading system

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through historical data.” All traders know that using historical data is not
the perfect solution to testing a trading system. A much better alternative
would be to have future data to test our trading systems. Failing that, historical data is the next best thing. There are many pitfalls and problems
associated with testing trading systems on historical data; however, the
consequences associated with trading a system in live market conditions
when it is not tested on historical data are much more problematic.

THREE GOALS OF BACK-TESTING
Your back-testing will allow you to do two things: First, you will identify
how suitable the trading system is for you. This does not mean you are
discovering whether the trading system is profitable, but, rather, you are
examining the fit between you, the trader, and the rules of your trading
system. Second, you will learn to trust your trading system and learn to
let go of your trades. You may trade in a more relaxed manner once you
have taken thousands of trades over years of market data. The confidence
gained by trading your system repeatedly will show up in the form of a
relaxed approach to your live trading. Third, you will gain expertise with
your trading system. This may only happen if you take many trades, and
back-testing is a quick way to accumulate many trades. A close look at each
of these three goals may help you to get the most out of your back-testing.

Is the System Suitable?
How suitable is your trading system? The first goal of back-testing is to find
out how suitable the trading system is for you. I have a good friend, who introduced me to forex, named Ashkan Bolour. Bolour is a well-known forex
trader, you may have read about him in the Millionaire Traders book by
Kathy Lien and Boris Schlossberg. Bolour trades the three-minute and fiveminute charts. He does exceptionally well trading these charts. No matter
how many times I watch him trade his systems on these charts, I always fail
when I try to trade as he does. I fail because his trading system does not
fit with my view of the markets. I prefer the daily, weekly, and four-hour
charts. I have great difficulty watching my trades fluctuate, which is precisely what Bolour does when he trades. I have learned to trade systems
that make sense to me. I am better at extracting profits from the longerterm charts. Your job is to find out how you should be trading, and trade
only what makes sense to you.
Perhaps you have traded several trading systems in the past. Most of
these systems probably looked outstanding at first glance. Maybe you paid

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for the trading system, and the website you bought it from painted the system as an invincible profit-collecting machine. Or maybe you read about
the system on an Internet forum. Or perhaps a friend told you about the
trading system. No matter how good the trading system appears, it is remarkable how your trading results often differ from your expectations of
the system. How can a perfect, profitable system fall apart in your hands?
Why is it that a system that sounds good does not work once you start
trading it?
The answer is fit; if a system does not fit your view of the markets, your
approach to trading, your ability to execute trades, it will not make money
for you. A system must fit with your understanding of the markets. If you
believe the five-minute chart is “random noise,” you may be better suited to
trade the daily chart. If you believe moving averages are useless indicators,
you will not be comfortable with a moving-average-based system. If you
think that the USD/JPY is a terrible pair to trade, you are not going to trade
a system on the USD/JPY. Your beliefs about trading must fit your trading
system.
Your lifestyle will also determine the types of systems you may trade.
If you have a full-time job, and spend 10 hours of the day at an office where
you will not have access to your trading platform, you probably will be
drawn toward longer-term charts. Daily, weekly, or four-hour charts may
be best for you. This way, you may take your trades and manage them by
checking the charts once or twice each day.
Your makeup as a trader will also determine how you should trade.
Perhaps you freak out when you are in a trade on the lower-timeframe
charts, such as the five-minute charts. Perhaps it is torture watching the
profit and loss fluctuate greatly with each pip gained or lost on these lowertimeframe charts. If this is the case, you will probably want to trade highertimeframe charts. If you are risking the same percentage of your account
on each trade, it is likely that a trade on a lower timeframe chart will risk
more per pip because the stop loss is closer to the entry price than a trade
on a higher-timeframe chart. Your back-testing experience with the trading
system will show you whether you will be able to find profits with a system.
Testing will also show you whether your lifestyle will fit with the system.
Perhaps most of the trade signals for a trading system occur during the
European market, and you are fast asleep during that time; this may mean
that the trading system is not for you.

Confidence Is Letting Go
After you have found a system that fits your personality, your view of the
markets, you need to get comfortable trading this system. This will be the
second step you take on your way to consistent profits in forex. The key

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here is to gain experience over a broad range of market conditions. Relaxing while you are in a trade will often help you manage the trade better.
Just the simple fact that you are relaxed means your decision-making will
be better.
Relaxation will come for you once you have confidence in your system,
a confidence gained by trading your system repeatedly, over years of market conditions and a variety of signals. You will learn to trust your trading
system and learn to let go of your trades. Micromanaging trades, particularly trades on higher timeframes, is a common mistake of novice traders.
If you can walk away from your computer after making a trade, you have
confidence in your system. This confidence is only available to traders who
have back-tested extensively.
Accelerate your learning curve by back-testing. It does not matter your
method of back-testing; it only matters that you do it. Testing over thousands of trades will enable you to be better prepared to make a decision on
your trading system. Once you deem your system profitable, you can begin
to get comfortable with the system by testing extensively, slowly building
your database of trading experience with the system. Your next step will
be to become an expert with your system.

You Are the Expert
The number-one reason traders fail in forex is this: Most traders do not
have expertise. Most traders begin trading a system without much experience trading a system. When the first bump in the road appears (e.g. an
extended losing period, a lack of signals for a week, a couple of difficultto-interpret signals, etc.) the system is abandoned. The traders who consistently pull profits from the market are experts, without exception.
To become an expert at anything, you must do it at least 10,000 times.
If you want to become an expert in your chosen trading system, you could
take 10,000 trades, which will probably take you years to achieve, or
you could back-test your system. By seriously testing your system over
thousands of trades, you will quickly achieve expertise with your system.
Seriously testing your system means making trades just as you would with
your live account: trading from the right-hand edge of the chart, without
the benefit of hindsight bias, using a strict application of your trading
rules.
The naked trader has an advantage over traders who trade “normal,”
indicator-based systems. A trader who is trading a system incorporating
seven indicators must view and interpret all seven indicators for each
trade, before, during, and after every signal is initiated. This is cumbersome and slow. The naked trader has a chart with no indicators, a very
clean chart. These charts are easy to interpret. In fact, the naked trader

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gains experience with his system every time he sees a chart in a newspaper, on television, in a book, regardless of market. This is because the
naked trader can see, at a glance, whether the chart suggests a buy signal, a sell signal, or no trade signal. A chart on the nightly news helps the
naked trader march toward expertise. In this way, the naked trader has a
distinct advantage over traders using indicators. Expertise will come more
quickly, more easily, and allow the naked trader to interpret any chart, in
any market, at any time.
Experts in cognitive psychology agree that experts at the highest level
find it difficult to teach their expertise. Experts know what to do, in
fact, because their expert behavior is automatic. They do not think about
what they do, they just do it. Novices spend a lot of time thinking about
the procedures, setting things up correctly, and so forth. Experts spend
time thinking about how they interpret information—a very different
approach.
So what does this mean for your trading? It means you should backtest extensively. Your goal should be to pull out of the novice trader stage
and into the expert level as quickly as possible. The fast way to achieve
expertise is to gain experience trading your system via testing. All novice
traders spend a good proportion of time in orientation, “Is this a good signal?” “Does this set-up qualify as a valid trade set-up?” “Should I take this
trade? I am not sure if this constitutes a good signal . . .” Expert traders
spend more time evaluating the trade once it is initiated. In other words, experts are concerned with Market Biofeedback, and novice traders are concerned with understanding the system rules. This is understandable, novice
traders spend time thinking about possible trade set-ups, novice traders
are still learning the trading system. Expert traders spend more time managing trades and focusing on making sure that open trades are managed
efficiently, to extract maximum profits from the market once those profits
become available.
One of the true paradoxes of expertise is this: Experts find it difficult
to verbalize the decision-making process. Expert traders are often unable
to adequately explain how to duplicate their results. This is frustrating for
the novice. Experts often rely on unconscious thinking, or a “gut feeling”
when making decisions. The subtle cues experts use to make a decision are
ingrained and rote, often inaccessible to conscious consideration, and this
is frustrating for novice traders who are seeking expertise. Novice traders
are better off spending time gaining experience through testing, building
toward expertise, rather than trying to find a shortcut to expertise by mirroring experts.
Unless you want to allow a computer to do all the trading for you—
in other words you trade only fully automated trading systems—you probably will want to achieve trading expertise. Your shortcut to trading

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expertise is to back-test. Although it may seem like hard work, the fact
is you can simply accumulate years of experience over hours when you decide to manually back-test. It is, quite simply, the best shortcut to trading
success. The very successful traders, who are consistently finding profits
in the market, who are trading for a living, all of them share one characteristic: They back-test their systems and earn their pips on their back-testing
software. Why not join this successful group of traders today?

MANUAL BACK-TESTING
Manual back-testing is the most readily available form of back-testing available. Most traders understand it is possible to manually back-test their
trading systems, but most traders choose not to manually back-test. Many
charting packages make it easy to back-test. The vast majority of charts
will allow the historical price, so that you may advance price slowly and
“trade” the chart as it unfolds. For example, in Meta TraderTM you simply
hit the F12 key on your keyboard to advance the charts one price bar at a
time. This is all that is needed for manual back-testing.

CANDLESTICK
The candlestick is a popular chart that displays the opening price, the closing
price, the high price and the low price for a market during a given time period.
Each candlestick clearly represents the important market activity for the given
time period.

To manually back-test, you simply scroll back in time and record your
trades, the trades you would have taken had you been trading the chart
in live market conditions. You can advance the candlesticks slowly, one at
a time, record your entry price, the number of lots traded, your stop loss,
and your profit target. You may be concerned that manual back-testing involves a lot of notes, spreadsheets, and recordkeeping. It is a meticulous,
involved, and laborious method of back-testing. It is also extremely powerful. If you aspire to trade by looking at a chart and making a trading
decision, you are nearly duplicating the trading process with this form of
back-testing.
Most traders employ discretionary trading systems, so it follows that
manual back-testing is the most appropriate form of back-testing for most
traders.

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Obviously manual back-testing will take some time, and it is sometimes
difficult to avoid “cheating” with this type of back-testing. However, you
must take care to avoid going forward on the chart and then reversing back
in time to take a trade you would have taken. The key is to trade as if
you are in that moment in time, with no information of the future. The
experience gained with manual back-testing is priceless. You can quickly
accumulate experience with your trading system if you back-test correctly.
Manual back-testing will yield statistics to help you understand the nature
of your trading system. These statistics, as we will see later in this book,
will become invaluable for determining how you should trade as they may
be utilized to project your results into the future.
A note about manual back-testing—it may seem tedious, it will take
some time, you may want to give up when it progresses slowly, particularly
when you are looking to accumulate hundreds of trades. Resist the temptation to avoid manual back-testing. Make progress in small chunks, an hour
of testing per day can give you a huge advantage. The payoff is great and
your experience testing your system will allow you to gain “experience”
trading the system through different market conditions. Each trade during
manual back-testing will march you closer to expertise. This expertise may
be the difference between you abandoning your trading system during the
inevitable drawdown, and maintaining confidence in your trading system
through a drawdown. However, there are pitfalls associated with manual
back-testing.
The most common pitfall traders fall into with this testing is engaging
in future trading by advancing the chart, either by accident or intention,
and then deciding that a trade would have been taken. Traders at times
have difficulty discerning when future price data creeps into manual backtesting. Traders who are strict about not allowing trades after future data
is viewed will avoid contaminating back-testing data. By trading only from
the current candlestick on the chart, serious back-testers avoid going forward in time.
Hindsight bias is a critical killer that may creep into your manual backtesting if you allow it to happen. A good rule of thumb is to advance the
charts slowly during your testing, and if you accidentally advance the chart
too quickly, you must keep your trades to the right-hand edge of the chart.
If you advance the chart and then go back to take a trade, you are leaving
yourself open to the hindsight bias.
HINDSIGHT BIAS
The tendency to overestimate the predictability of the market after the future
outcome is known.

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Even if you only take trades during testing by advancing the chart one
candlestick at a time, hindsight bias may still sneak into your testing. If you
are testing historical data on the EUR/USD in 2008, and you had experience
trading in 2008, you may have a problem. Your subconscious may be pulling
up the 2008 EUR/USD chart and you are obviously not even aware of it. To
fight hindsight bias, take trades on the right-hand edge of the chart, do not
go forward on the chart and then reverse back, and if you do accidentally
go forward, resign yourself to skipping over any signals that pop up and
stick to trading on the right-hand edge of the chart.

USING BACK-TESTING SOFTWARE
Back-testing software is a step up from manual back-testing. Most forex
traders are not even aware of the fact that manually back-testing your
trading system is possible. Back-testing software is an underappreciated
tool, one that will allow you to manually back-test your trading system at
an aggressive pace. Manual back-testing software records your trades for
you and enables you to quickly take trades as you advance the historical
charts. In many ways, manual back-testing with software is not much different from manual back-testing. The advantages to using software are as
follows: Software will allow faster testing, so you may accumulate experience quicker; the software will do the recordkeeping for you and allow you
to concentrate on the trade signals; you may easily export your data for
analysis; and software discourages cheating— manual back-testing software is a hindsight bias killer.
Of the many manual back-testing software packages available, my favorite is Forex Tester. Forex Tester is a manual back-testing software
package that will allow you to import any data. You may decide to import
forex data, futures data, stock data—any data will work. Forex tester will
record your trades and allow you to export your trading data into a spreadsheet, after you have completed your testing, for analysis. The beauty of
software-based testing is that it allows you to concentrate on trading your
system. In many ways, it mirrors live trading with an account platform. If
you would like to see a video demonstration of Forex Tester please go to
www.fxjake.com/book.
There are many traders, myself included, who will spend more time
back-testing with software because it is much easier than manual backtesting. Back-testing with software helps traders gain years of trading experience in a few hours. However, the real work in back-testing is examining
the results. Exporting and analyzing the data from back-testing is where
serious traders validate trading systems, find behavioral patterns, and

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develop strategies to augment profitable trading strategies. These data are
gold for the serious trader.
Your back-testing data will help you determine your trading patterns
(Do you find profits more easily on the daily charts? Are most of your winning trades initiated during the European session? Do you trade particularly well with your system on the CAD/JPY?), and this can lead to more
fruitful back-testing sessions. You will also know, after back-testing your
system over several hundred trades, if the system makes money for you.
In fact, before you ever risk one cent, you should make hundreds of trades
while back-testing to verify that your trading system will capture profits
and also to gain expertise with your system.
Manual back-testing with software is not without problems. You must
look out for the same pitfalls that creep up with manual back-testing,
namely hindsight bias. Manual back-testing software makes it easier to
avoid hindsight bias, but you still must be careful to only take trades if
you have not advanced forward on the chart. Cheating is not allowed when
back-testing; your goal is to generate realistic trade results during your
back-testing. Also, because it is very easy to quickly execute trades with
the testing software, you must watch out for subpar trades. Trades you
would not take on a live trading account should be bypassed no matter
how tempting it may be to take them during back-testing. Try to back-test
as if you have real money at risk. This is the only way to ensure that your
statistics and experience in back-testing will closely match your live trading. If you remain vigilant and conscientious during testing, your results
will be more meaningful.

AUTOMATED BACK-TESTING
Automated back-testing is the most well-known method for testing a trading system. Most forex traders are aware of the fact that it is possible to do
some automated testing on a trading system. However, most forex traders
use discretionary, or manual, trading systems, so automated back-testing
is not the ideal method for back-testing; it does not closely duplicate the
discretionary trading most traders engage in. There are many reasons for
discouraging automated back-testing for discretionary traders:

r There may be too much human interpretation in the trading system.
Automated back-testing does not allow for the human interpretation
of trade signals.
r The trading system may involve variables that are not available on the
price chart (news releases, economic data records, interpretation of
world events, etc.).


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