Chapter 7
What to do to
Improve Your Trading
Make a Trading Plan
The best traders have a plan and stick to it. Most winners in trading are working to a trading plan and treat trading seriously and as a business. No one would seriously expect to succeed in business without a plan.
Merely opening a brokerage account, reading a couple of books, and starting to trade is not a business plan. A plan should be written down, with clear instructions that should not change while the market is open. Plans can evolve but not just in response to a loss or a piece of news. Adjustments to your trading plan should be tested and considered.
A personal plan
Trading plans are very personal. There’s no template for a trading plan. Your amount of risk-capital, risk appetite, level of skill and experience, the amount of time you have available for trading, and many other factors determine your trading plan. This is a personal plan and unique to you. Using a template or someone else’s trading plan will not reflect your circumstances and characteristics.
Assess your skills
Are you ready to trade? Have you paper traded (Demo traded) and confident that what you will do will work in the real world? Can you follow your own trading signals with discipline and without hesitation?
Are you mentally fit to trade?
Trading is mentally challenging. You need to be mentally and physically fit to trade successfully; you must be sharp. A recipe for losses is to feel unwell, headache, flu, tired, angry, or argued. At these times, you are distracted and preoccupied and should really take the day off. Being physically and mentally fit is a great contributor to profitability.
What is your risk level?
How much of your account should you risk on a single trade? This will depend on your trading style and your personal risk tolerance. The monetary amount of risk can vary but is frequently in the range of between 1% and 5% of your account on any given trading day. That means that if you lose that amount at any point in the day, you close down for the rest of the day and stay out. It is better to take a break, and then rejoint the battle with a clear mind.
What are your goals?
Before you start trading and before you enter any trade, set a target. What is the minimum monetary risk/reward ratio you will accept for a trade? Many traders will not trade unless the potential profit is at least three times greater than the risk. For example, if your Stop Loss is USD 500, your goal should be a profit of USD 1500 or more. This type of risk-reward ratio is unrealistic for day traders who may rely on a high ratio of profitable trades to losing trades rather than a high ratio of money gained versus money risked. Set monthly and annual profit goals for your trading and reassess yourself regularly.
Prepare to win
Every day before the market opens, you must check what has happened overnight and what news is expected for today. Have markets moved up or down?
Tip: Did the S&P move overnight? Any significant move there may influence USD today. Overnight moves in the stock market set the tone for the day in the forex market.
What economic or other data is due and when? What is expected of the news? Will you trade through the news or stand aside when the news is being released?
Tip: Remember, trading ahead of important news and reports is often a gamble because no one can know how the markets will react. Most traders should wait until after the news is released rather than taking unnecessary risks associated with the companies’ volatile reporting period.
Prepare to trade
Whatever trading method you use, label major and minor support and resistance levels, pivot levels, chart patterns, flip levels on the chart or make a note of them in your trading log. Set alerts for these levels and make sure all signals can be easily detected with a clear visual or auditory signal.
Time to enter
You have a system or plan that is simple enough to make a snap decision. As time goes on and you become more experienced, your system or plan will likely become more complex. At some point, it may be necessary to use a computer to keep track of the criteria for you. Computers do not think, get sick or have emotions. They just do as they are told. If your conditions are met, they tell you to enter. They tell you where your Stop should be and where your target should be. Computers execute trades much better than people, without emotion. The idea for the trade and the design of the system is the product of the clever trader. But he or she passes the boring part of the job, tracking the conditions and the trade into the hands of a tireless computer. This explains why most of all trades occurring are generated by computer programs. This is not limited to high-frequency or Algo trading and people executing their orders using a computer.
Tip: If you have many conditions that have to be met in your trading system, particularly if some criteria are subjective, you will find it difficult or impossible to make a trade. This is why many traders eventually move towards a systematic approach to trading and use a computer to evaluate the conditions and alert you when they are met. This is something computers do well. They will be able to evaluate accurately, without getting tired and will never make a mistake. If your plan is good and profitable in the long term, the computer makes sure you don’t miss a trade.
Think carefully about how to enter your position. Should you trade at market? On Stop? At a price level? What are you trying to do? You should be very clear in your plan and know what your objective is. If you are not clear, you are simply gambling.
Tip: Buy or sell at Market when you are sure now is the right moment and you will not be able to get a better price. For example, it may be that you’re not quite sure if the market will hold at a support level. But if it does, it would be a good idea to buy it. Therefore, place a Buy Stop Order above the support level to catch the move as the price bounces from the support. As it starts to make the price move that you expected, you enter the trade using the Stop. The advantage is that if it does not bounce at the support level as you expected it would, you have not bought. You may also scale onto a position and place Buy orders at levels below the market. Otherwise, it is best to trade at Market or On Stop.
Time to leave
Before entering a trade, you have to plan your exit. Only then do you know the risk of your trade. Your trading system, or your major support or resistance levels are broken on the chart; you should have already set alerts or placed orders to exit the trade. These will be Stop orders.
You may have set a target for your trade and can have a resting level order to close out your position. As an alternative, you may maintain a Trailing Stop to capture a profit even if you do not reach your target.
Tip: You have three outcomes from a trade. You may enter the trade, and it may move against you, and you may be stopped out at the level that you decided at the start of the trade. You have lost the amount you risked. Another outcome is that you enter the trade and it starts to move in your favour, and you can move your trailing stop in the direction of your position. Once the Trailing Stop has moved beyond your entry price, you have now assured some profit. Whatever happens now, you cannot lose. The only outcome for the trade is break-even or a profit. Lastly, you may enter your position, and the price may move in your favour, and eventually move onward to your target where you exit using your resting order. Remember to cancel the Trailing Stop.
Tip: These levels should have been decided at the same moment the trade is entered. Never after. This is your plan.
Keeping a log
Most successful traders are meticulous at maintaining a trading log. They record when and how they made their profits and losses over time. Most importantly, they want to analyse their losses to see if there is a lesson to be learned or not.
Tip: Losses are inevitable, and you should not assume that a loss was a mistake. Many losses are deliberate to ensure it is a small loss. Running profits and cutting losses means you will inevitably take frequent small losses but allow the remaining good trades to run. It is right to take a loss small as it means you are preserving your capital to ensure it is never game over.
The trading log is like a diary, detailing trade Targets, Stop Losses, time in the trade, support and resistance levels, observations and expectations at the time, the open and close for the day and other pertinent data. Record comments on the reason behind the trade, the plan details and reasons for changes in orders. Memory after the event is not reliable so diarise as you go.
You should also save your trading records in a way that you can go back and analyse your profitability over time, your drawdowns, average time per trade – required to calculate trade efficiency, and other important data. You can then compare these factors to a buy and hold strategy. In this way, they can see that their trading is worthwhile and are you getting better?
Tip: Always remember trading is a business and your trading log is your accountants’ ledger. You will not be a successful businessman unless you keep good records and analyse and learn from your experiences.
Look at Yourself
At the end of each trading day, look at your trades — the winners and losers, – but most importantly ascertain why and how the profits and losses were made. By doing this, you will relieve the pain of the loss but learn from it.
Tip: Be your own worst critic. Did you do anything wrong in that losing trade? In the same circumstances should you do the same again? Was that profit as good as it should have been? Did you break a rule and take the profit too early? Make a note of your conclusions so you can reference them later. Keep learning. They will always be losing trades. What you want is to develop a trading plan that wins in the long run.
Demo Trading
Trading successfully in a Demo account does not guarantee you will be successful when you start trading with your own real money. The big difference is, with your own money, emotions now play a big part. Losses are easy to take with pretend money. Losing real money hurts. Successful practise trading does give you confidence that the system you are using, will work if you apply it with discipline.
Tip: Deciding on a system is less important than gaining enough skill to follow your plan, including stopping yourself out, without second-guessing or doubting the decision. Confidence is essential for successful traders.
There is no way to guarantee a trade will be a winner. The trader’s chances of winning are based on their skill and the system they are using. You cannot win without losing. No one does. In reality, many of the most successful traders lose more often than they win. But their wins are bigger than their losses. This is because they are cutting their losses and running their profits. This is how you win the war while losing some battles. Battles are not important. Winning wars is.
Consistent winners treat trading as a business. Having a plan is crucial if you want to be in that elite group of consistently successful traders.
Tip: Most traders lose money. They also lose it quickly and leave trading disappointed and disillusioned. They all have in common that they had no plan and were not treating trading seriously. They were gamblers and poor ones at that. Trading is fun but becoming one of the elite traders is not easy. It requires work, effort and tenacity. It’s a challenging endeavour but well worth it in the end. Without this attitude, and if you are lazy, you will become one of the majority. By taking the time to read and learn from this course, you are taking a big step towards joining the elite traders club.
Risk management
Trading is a game of risk, but all too often, it is the last thing that traders think about. Frequently, they concentrate on the profit opportunity of the trade. It’s a basic human instinct to look for the wonderful rewards available to you.
Tip: You trade because you think you can win. Why else would you trade? In reality, it is most important to concentrate on the risk to stay in the game for the long run.
Successful traders treat speculation as a business. People in business make plans, have a budget, do cash-flow analysis. They are wary and respectful of the risks they must take. They plan for the unexpected. To be a successful trader and join this elite group, you must do the same.
In trading, there is always a risk that you will lose money. Risk comes in many forms and different sources. These are the main sources of risk which may not be readily apparent or could be overlooked.
Liquidity
Forex is the most liquid market in the world. But currencies are still subject to varying liquidity trading conditions at different times. Liquidity is the amount of market interest present in a particular market. For an individual trader, equity issues are experienced in times of volatility in the price. Highly liquid currencies will tend to see prices move more gradually and smoothly and in smaller increments. A less liquid currency pair will tend to see prices move abruptly and in larger price increments.
On any day the peak of liquidity is when the European and London markets are open, overlapping with the Asian sessions in their morning and the North American markets in the European afternoon. Following the close of the European trading session, liquidity drops off sharply as we move into what is called the New York afternoon market.
Reduced liquidity is first evident during the Asian trading session, accounting for only about 17% of the daily global trading turnover. Japanese data or comments from officials may provoke larger than expected moves or more persistent reactions simply because there are fewer large traders around to counteract the directional moves suggested by the news.
During periods of reduced liquidity, currency rates are subject to moves which can be sudden and volatile. The spark could be a news event or a rumour, and the reduced liquidity sees prices react more abruptly than would be the case during more liquid periods.
Another common source of erratic price moves during less liquid periods is short term market positioning. A classic example is a strong rally in the currency pair during the North American morning/European afternoon. As European traders head home, the currency pair typically settles into a consolidation range near the upper end of the day’s rally. If sufficient short positions have been established on the rally, further price gains may force some shorts to buy and cover. With reduced liquidity, prices may jump abruptly, provoking a flood of similar buying from other shorts resulting in a squeeze and stop losses forcing the price higher.
There is no way to predict with any certainty how price movements will develop in such relatively illiquid periods. The bottom line is if you maintain a position in the market during periods of thin liquidity, you are exposed to increased risk of more volatile price action. Liquidity is also reduced by market holidays in various countries and seasonal periods of reduced market interests, such as late summer around Easter and Christmas holidays. Typically, holiday sessions resulting in reduce volatility as markets succumb to inertia and remain confined to ranges. The conditions increase for sudden breakouts and major trend reversals. Aggressive speculators such as hedge funds exploit reduced liquidity to push markets past key technical levels, which forces other market participants to respond, propelling the breakout or reversal even further. By the time the holiday is over, the market may have moved several hundred points and established an entirely new direction.
Volatility
Price volatility must be embraced and respected. Without volatility, there is no opportunity for traders to make profits. Extremes of volatility, both high and low, can be a severe problem for traders. Volatility is a statistical term referring to the average price fluctuations relative to the average price over a specified period. Volatility is what makes the trading world. There are two main types of volatility in determining the nature of the forex market playing-field.
Market volatility
Market volatility is the overall level of price volatility in the market at any time. Market volatility typically increases during periods of uncertainty or unexpected changes in monetary or currency policy. Increased short-term volatility tends to participate even greater volatility until markets have had a chance to adjust prices and establish a new equilibrium. If you’re trading on a short-term basis or using a model that relies on relatively low volatility, for example, and mean-reverting system, moving averages, or regression channels, you need to be aware that increased volatility can quickly swamp such strategies. Better to stay on the sidelines and sit out the upheavals than jumping in with a strategy that isn’t suited to the more volatile conditions.
Currency Pair Volatility
Currency pairs have varying volatility characteristics. It’s important to know the pairs relative volatility before you make a trade.
Tip: Is GBP more volatile than the EUR? Yes, it generally is. Make sure you understand the risk of GBP compared with EUR. Must your Stop Loss order be wider to avoid being stopped out in normal GBP volatility?
Mind the gap
A gap is formed when any security price instantaneously moves from one level to another without trading in between. This is a risk to traders and is called gap risk. They typically occur when there are events like economic data reports, central bank rate decisions, and other news events or shocks. It’s important to remember that gap risk is usually identifiable in advance by looking at the data and event calendars. But no one can predict a true random shock event such as the assassination of a key politician, an unexpected rate change, a key person resignation, IT failure, Brexit… These sorts of events are random and rare and crucially unexpected (unlike news releases).
For this reason, the market is taken by surprise and price moves can be extreme and very gappy. These are unexpected shocks as opposed to surprising economic numbers which are expected shocks. Unexpected shocks are surprises and cause big moves in thin trade.
Gaps vary in size depending on the nature of the news; gaps of 2280 pips or more are not uncommon in currencies, even liquid currencies such as the euro, after major news and data events. Gaps occur because the interbank market reduces its bids and offers in the minutes or so immediately before and after announcements, leaving online currency trading platforms with no prices to show traders and no place to hedge their positions. The interbank market does not want to risk being a market maker when the price can go significantly against them in microseconds. However, they will quickly resume quoting after the initial shock as they want to participate and profit from volatility. After the news is out, interbank traders adjust their prices to reflect the news, resulting in a price gap higher. It can be up to 30 seconds or more depending on the news or event before normal pricing reappears and online brokers can hedge and execute properly again. Remember, interbank traders, even though they can react very quickly, are subject to gap risk as individual traders. They will not quote to brokers while they are readjusting their prices.
Tip: if you’re holding an open position at the time of a major data release or event, you’re exposed to gap risk. The same goes for your Stop-Loss orders left with your broker — Stop-Loss orders are subject to gap risk. Depending on market circumstances, Stop-Loss orders will see slippage (meaning, your Stop-Loss order may not be filled at the rate you specified). In the case of price gaps brokers are obliged only to fill your order at the best price basis.
Important: Gaps from unexpected news can be so violent that they take out all stops both above and below the price before the news. The time around important news events is perilous for short-term traders. Most astute traders simply sit it out. They know it is too difficult to quantify the risk during this period. For longer-term traders volatility spikes at times of news releases are not such a problem as their stops are placed much further from the market.
Big gaps can occur over weekends, potentially resulting in substantial gaps between Fridays close and the Sunday/Monday opening. Weekend gap risk is usually also identifiable in advance. Firstly, it is a weekend and gaps are always likely. Secondly, the weekend may include market-moving scheduled events like the G7 meeting or other high-profile events.
There is also the potential for unexpected, shocking events (earthquakes, snow, terrorism, currency revaluations or devaluations, Black Swan events) to happen over the weekends. To judge the risk associated with a weekend, you need to have a good sense of what’s going on in the world and a healthy sense of expecting the unexpected.
Tip: The bigger the shock to the market, the bigger the move in the price. The more positions wrong-footed by the news, the greater the scramble to get out. The safest approach is simply not to hold positions over the weekend.
Leverage
Leverage (or gearing) is the size of the market position you can control based on your available margin collateral. If the leverage is 10:1, and you have USD 1000 of available margin, you can hold a position equivalent to USD 10,000. Leverage is a great trading tool, allowing traders with less capital to participate in markets they couldn’t trade otherwise. But leverage is still just a tool. As with other tools, if you learn how to use it properly, you’ll be able to get the job done well. But if you don’t learn what works and don’t respect it, you’re heading for certain trouble.
Tip: It is important, not only to see the upside benefits of leverage – the larger the position on a profitable trade, the more profit you will get. Leverage will magnify your gains, but it will also magnify your losses, the larger the position on the losing trade, the larger loss you will experience. It would be best if you had a healthy respect for the downside risk in trading, or you won’t last long. It will be game over quickly. Leverage is a double-edged sword.
Leverage is seductive. Just because you’re able to have 100: 1 leverage doesn’t mean you have to use it. It may feel good to be a big trader, but you must not use it to massage your ego. Trader vanity only has one result. Be a humble and respectful trader.
Keeping winners
Losing in trading is part of the facts of life for a trader. Losing is part of the winning process. This is particularly so for disciplined traders who cut their losses and run their profits. Their ratio of losses to profits may be relatively high, but in the end, they add up to much bigger overall profits than the frequent small losses because they run the profits. Overall this leaves them with a positive long-term outcome. When we get the direction right, we want to maximise the profit from the trade. We do not want to have winning traders trades turning into losses.
Tip: Managing a winning trade is often more difficult for experienced traders, than getting stopped out of a bad trade. Once you enter a trade and place a stop and the market moves against you and unfortunately stops you out, that’s a simple trade that didn’t go well. That is you cutting your losses while they are manageable. It is your Trading Plan in action. All your thinking was done pre-trade entry. You placed the stop at the right place, and it did its job of getting you out because the trade was wrong. But if you enter a position and the market moves in your favour, you have decisions to make to manage your profit. This is both technically and mentally complex. You are pressured to let the profit run while suffering the fear your open profit may evaporate. This is why inexperienced traders often take their profits too early and miss the big profits which should be there. If your plan did not include a process for managing your profits you are deciding what to do while watching your P&L go up and down. When you are under this sort of pressure, it’s tough to think clearly. This takes discipline and experience. New traders have neither.
Managing using orders
Traders’ two popular orders types to manage their profits and attempt to maximise their trades are Targets and Trailing Stops.
Targets should be set at the start of the trade during your planning process. They should be attainable and relate to the risk of your trade. The risk is the difference between the entry price and the initial stop loss (minus slippage). The reward is potentially the difference between the entry price and the target. The ratio of the risk to the reward is the attractiveness of a trade. A risk-reward ratio of one to five is a more attractive proposition than a risk-reward ratio of one to three. If you risk one to gain 0.5, then you will need to be profitable twice as often as you lose. That is a very tall order for any trader. Many of the most successful traders lose more often than they win, but each time they win, their profits are much larger than their losses. This is a trading edge in the long run. For example, if you lose six times out of every 10 trades, but win 3.5 times as much on the four winning trades then you have a trading edge.
Targets should be set at technical levels, not just because they are three times the risk. The level you are choosing must have relevance, such as support or resistance.
Trailing stops can be used in combination with targets. A Trailing Stop Loss is a Stop-Loss order that automatically follows the market at a user-defined distance, for example, 35 pips. Say you shorted the EURUSD at 1.1880 and had a 35-pip Trailing Stop Loss. The Stop starts pegged at 1.1880 and is therefore at 1.1915. The market moved in your favour – lower. And the stop will adjust to 35 pips above the lowest low so far. If the EUR trades down to 1.1845 your Stop will be at 1.1880 – your entry price. The trade has now got only two outcomes: break-even or profit (less any slippage). Suppose the EUR trades down to 1.1780 bringing the stop to 1.1815. The market bounced from the 1.1780 low and up through 1.1815, and you are stopped out. Not at a loss but a profit. You entered short at 1.1880 and exited at 1.1825, rising a maximum of 35 pips.
Tip: Trailing Stops are excellent for catching big moves as they allow the market to go somewhat against you, but you hold on and run your profit. Sometimes the market will run and run, and you will get one of those nice big winners. With a tight stop, they are impossible.
Chartists may prefer to trade according to technical levels. They will want to consider manually adjusting their stops after specific technical levels are broken. For example, if a trader is long, they may raise their stop loss from its original level after technical resistance has been broken. This manual stop adjustment method requires discipline and skill. Trailing stops have the advantage of being mechanical and rules-based. With a Trailing Stop, you automatically follow the market and leave when it changes direction against you.
Tip: Most importantly, if the market reverses and your profit starts to decline, don’t worry about the paper profit(Demo profit) you have lost, worry about keeping what you’ve still got.
Slippage
Slippage is made up of two parts. The first part is the difference between the Bid and the Ask of the currency pair. The second part is the broker’s execution policy. The difference between the Bid and Ask is usually extremely tight in major currency pairs. See the section on the liquidity for an explanation of when this is not true.
FXChoice, in common with other major dealing platforms, operates on the basis that a limit order to sell is executed when the Bid price reaches the order price. A limit order to buy is filled when the Ask price reaches the order price. In the case of stop losses, an order to sell is triggered if the Bid price reaches the order rate, and a Stop-Loss order to buy is executed if the Ask price reaches the order price. In both cases, the dealing spread works against the order, and the trader needs to be aware of this and take it into account.
For example, you may be long of the EUR at 1.1750 with a take-profit order to sell at 1.1830 and a Stop-Loss at 1.1712. For you to make a profit, the quote has to go to 1.1830 Bid – say 1.1830/32. If the highest price quoted is 1.1828/31, your trade will not be executed. It must go Bid at your Target price for you to sell it to someone. Your Stop Loss would be hit if the quote goes to 1.1712/13. If the quote drops to 1.1713/14 and bounces, you are safe, and the Stop was well-placed and did its job. Remember the quotes change in micro-seconds, and you may not see the speed going to your Stop level.
Liquidity Issues
It is vital to remember liquidity issues. Even the Euro spreads widen on certain occasions.
Watch out for wider spreads
- During the night
- When there is news
- Pre-London opening
- Late on Fridays
- Over the weekend
- Holidays
- Random inexplicable occasions
Tip: Slippage is a lurking danger and must be respected. Smart traders factor it into their risk-reward calculation in their plan. They know it is there and subtract an average amount to their risk calculation.
Support and Resistance Levels and your Orders
Many traders use technical support and resistance levels to help them place their orders. Say you were long the EUR and had a Target sell order to take profits at 1.1830. You may have chosen this level because it was a resistance level (e.g. a previous high, a trend line, a Fibonacci level). There may be many other sell orders there as other traders see the same as you. If there are a lot of sellers at that level, the market may never get to that high because savvy sellers step in front of the resistance level, start selling and stop prices from reaching it. Scalpers make a living from doing this. If they know there are lots of sellers at 1.1830, being short just in front at 1.1828 and knowing that they have a lot of orders protecting their position. They hope they will get enough of a sell-off as the 1.1830 sellers lose patience to take a short-term profit from the selling weight. This is a low risk (though not risk-free) trade for them.
Let us say you have a long position in the EUR with a protective Stop at 1.1712. You chose this level because the market had bounced from that level twice before. Many others will be doing precisely the same as you leaving a bunch of Stops at 1.1712. Scalpers will sense this and look for the opportunity to downtick the market to cause many stop losses to be hit, giving them a profit from there downtick trade.
Tip: It is not banks who do this as the profit would be too small for them. These stop hunters or scalpers are savvy professional speculators. They rely on inexperience small speculators leaving their orders and stops in obvious places. It requires a great deal of experience and skill to do this profitably. Sometimes these savvy traders are caught when, for example, they think they have triggered a stop and are short but the price flips around as the level holds and they are brutally punished for their cleverness.
Where to place stops?
There are two ways traders use as a basis for deciding where they place their Stop-Loss orders:
Technical Stops: A technical Stop is placing a Stop-Loss order according to a price level identified through technical analysis. Whatever technical approach you choose to follow, you’ll be looking to identify key technical points that, if exceeded, will invalidate the trade setup and signalled that it’s time to get out of the trade.
Tip: Remember, a support level such as a previous low is not the place to place your Stop. It is a support level and has held previously. It’s the breaking of that support level that is your signal to get out. The level has not been broken until the price moves below the support level. It would be best if you placed your Stop Loss close to but below the support level.
Financial Stops are based on the amount of money you’re prepared to risk on a given trade. You may base the trade on a fundamental or even technical view of future developments, but you’re willing or able to risk only a certain amount of money on the trade.
Financial stops are favoured by conservative traders who do not want to risk more than a fixed amount on any single trade. It is a comfortable way to operate.
Tip: Remember, financial stops are essentially arbitrary and have no relation to the market itself. It’s just your personal pain level. The market doesn’t care about your pain level. Your pain level may be too far or too close. The best stops are placed at meaningful levels.
Important! Technical stops and trades are based on an analysis of the past price action. This is about the only way that traders can make forecasts of future price movements.
To give an example of this, imagine AUD testing a 0.68 area, and buyers keep buying enough to make it bounce, but suddenly the buyers are not there and it breaks down through 0.68. In this instance, it was probably the buyers who were holding the price and created the temporary support level; they have bought enough and are not buyers anymore. The Support has been broken, and prices can now move lower in the absence of buying. In the long run, this is generally true.
Knowing this about market behaviour gives you an edge. There is no certainty, but we will most likely move lower to the next Support level. Trading and Analysis is a probability game. In the long run, if you have a plan built on good technicals, you will have enough of an edge to join the elite traders. Without the skill, discipline and plan, you will join the majority of the traders.
Trade Risk Management
Position sizing
Before making a trade, consider its risk. It should never be an afterthought. Some traders think, ‘why would I put on a trade if I expect to take a loss?’ Experienced traders calculate the risk they are facing in every trade before they enter it. Trading is a business and analysing the risk before the trade goes a long way towards determining which opportunities you should take and which ones you should skip. Risk management should be at the forefront of your thinking before you enter any trade. You will still get some trades wrong, but you will survive to get trades right.
Your trading plan
Proficient traders always have a trading plan. The most important part of a trading plan is the size of the position that will be traded. Position size will determine how much money is ultimately at risk, as well as the overall viability of the trade itself. Some trades look good and promising but do not match the trading plans risk-reward criteria and are therefore rejected by the plan as unviable. It does not matter how strongly you feel about the prospective profitability of a trade if it does not meet the criteria of your plan; it must be rejected.
The initial risk should only decrease, never increase
The initial risk of a trade should never be allowed to increase. The initial risk is the difference between the entry price and your first Stop-Loss price measured in pips, per cent or a number of dollars. We know that there may be slippage in the Stop Loss but let us assume for a moment that there is none. Whether you choose to define the risks in pips, per cent or dollars, the answer should be the same: a percentage of your total available risk capital.
Important! Your Initial Stop Loss should only be moved forward if the trade develops in your favour. If it does, protection can be moved only in the direction of your position, never against, otherwise, the trade risk will increase. If the Stop Loss had moved beyond the entry price, you are now in the enviable position of a risk-free trade. The only outcomes (less slippage) are break-even or a profit. If the price moves further in your favour and has not yet reached your target you can move the Stop (no longer a Stop Loss) further, and your only outcome is either a hefty profit (at the Target ) or a good profit if the market reverses, and you are stopped out but beyond your entry price.
Your trade setup
Your trade setup is defined using fundamental and/or technical analysis. You use your skills to determine the entry, protection, and target levels that meet your trading plan’s criteria. In every trade, you will need to identify the price at which the setup is wrong where the trade is invalidated. If you were looking to buy a currency pair based on a trend line support below, and the price then falls beyond the trend line that would invalidate the rationale for being long. So the price level of the trend line determines where your Stop Loss is. If you long the currency pair because you expected it to go up and then it goes below the trend line you know the trade is wrong and you must get out and cut your losses.
Tip: If you stay in the trade after you know it’s gone wrong, then you are just waiting for the loss to become big enough to hurt. Be glad the loss was small and manageable and left you with capital to continue trading.
Position Size = Account Equity/Percent risk per trade X Initial Risk
Risk:Reward Ratio = (Entry price – Initial Stop) in pips: (Entry Price to Target) in pips
Where to enter the trade
Let’s say the current market price is 50 pips above a support trend line you have identified using your technical analysis skills. That means the market could move lower by 50 pips, and your trade setup would still be valid, but you’d be out of money by 50 pips before you know you are wrong. However, you have a clear idea of how much risk your trade setup would require you to assume. If you enter the market now, you’re risking at least 50 pips. This may be too much for you?
You could reduce the risk by waiting and using an order to try to buy at a better level say, 25 pips lower. If the market is good enough and allows your entry order to be filled, you’re now risking only 25 pips before your trade is invalidated. But now you have a new risk: the market may not be obliging and allow you to enter closer to the trend line. The market price could move ahead, and you have not entered cause that the risk was not attractive, but you were right in your market view that the trend line would hold. With a trading plan, you have rules to determine when a trade cannot be taken because it is not attractive. Your plan will stop you taking trades that you like the look of but simply do not add up from a risk-reward perspective.
Position sizing
So how large a position should you commit to the trade? It depends on what price you can enter the trade relative to your initial Stop-Loss level from a risk standpoint.
After you have determined where to enter and where your trade would be negated (your initial Stop-Loss level), you can calculate the amount of initial risk posed by the trade. Remember, there is probably going to be a small amount of slippage too.
Say you want to enter a position at current market levels in the AUDUSD pair, and your stop is 50 pips away, below the support level you have identified. If you are trading a standard size account (100,000 lot size) and AUD (where the profit loss accrues in USD), each lot would translate to a risk of USD 500.
If your margin balance is 10,000, you’re risking 5% of your trading capital on this trade. Is this the amount you want to risk in your trading plan? If you were able to enter the position at a better level say, using an order to sell 25 pip better, you’re now only risking 25 pips on the trade. You could double the position size and still be risking the same amount of capital, or you could stick to the single lot and cut your risk in half.
Important! Both gamblers and traders are subject to the vagaries of luck. But, unlike a gambler, a trader has total control of the risk of their bets. The odds are rigid and set for a gambler. This is the difference between intelligent trading and gambling.
The risk of your trading plan
Risk in the training plan is not confined simply to losing money on the trade. There are also opportunities/risks from trade setups that you’re not able to take because your money is tied up elsewhere. You may also be considering a trade setup that involves buying a dip towards a significant support level, but what happens if that dip never comes?
Trade entry point
Winning or losing on a trade is difficult if you never get into the position in the first place, which makes identifying where to get into a trade one of the most critical steps in any trading plan.
Most traders like to use technical analysis as their primary means of identifying entry and exit levels. Technical analysis has the advantage over fundamental analysis of providing price levels that are vital for creating a trading plan. Fundamental analysis may tell you whether a thing is bullish or bearish or should go up or down but does not answer the big question for traders: when or what level is a good place to enter and when and at what level do they know they are wrong? These are critical for traders.
In attempting to identify entry points, focus on the following technical levels:
- Trend lines in various timeframes (daily, 4-hour, and hourly)
- Hourly highs and lows for short-term intraday position entries
- Daily highs and lows for medium-to-long-term positions
- Congestion areas
- Fibonacci retracements of prior movements (38.2%, 50%, 61.8% and 76.4%)
- Spike highs and lows
- Chart patterns
Once you have identified a price point to enter a trade, double-check the level. Is it a good number? You want to avoid obvious numbers like round numbers. Many orders are placed at round numbers. You may want to get ahead of the crowd by paying a little bit more. This will lower the risk of missing the entry.
What happens if the market never gets to your level? What’s your backup plan? If you were planning to sell on a rally, for example, but the market moves directly lower, is there a price level you would consider selling at a Stop-Entry basis? What does the backup plan mean for your overall trade stop level? Should you be reducing the position size to compensate for the worse entry price?
All the thinking about this and the formulation of your plan should be done before you enter a position. Then it all becomes a process. No consideration is done under pressure over a P&L moving up and down for and against you. It is near impossible to think clearly under fire.
Tip: For the best traders, order placement is predetermined, including their backup plan, and trading is a relaxed affair for them. For them, trading is just a low-pressure automatic process. They have confidence in what they are doing, and they know that they can’t think clearly while they are in a sticky position so everything has to be preplanned. This does not come naturally. It needs practise and training. But it should be the goal of every trader who wants to have a long and profitable life in the markets.
Your Stop Loss Placement
To determine the risk of the trade and decide whether it is worthwhile entering, we first need the entry level and then, second and vitally, the initial Stop Loss. The initial Stop Loss is the point where the trade setup is negated, and the suggested strategy has failed. The best time to determine this is before you have put any money into the markets. This is the clear-thinking and planning time. The Stop-Loss level should be set, not at some financial pain level for you, but a technical level which makes sense. The market will not respect your personal pain levels. But it may well respect technical support and resistance levels.
Like other actively traded markets, the forex market tends to penetrate levels where Stops are likely to be located. Because of their limited capital, small traders often place their Stops too close to the level and right in the noise of the trading at support levels while the market decides whether to hold or fail. Nothing is worse than having a correct strategy but being stopped out by a short-term, Stop-Loss-driven price move that eventually reverses and goes in the direction you first thought it would.
Place stops defensively to try to avoid the whipsaw trading action. Realise the market will test the level. Place the stop beyond that level but not so far away that the loss is unbearably large.
Important! Wide Stops mean that you will not be stopped out in the noise as support and resistance levels are tested but mean that the loss is large every time you are stopped out. The skill is to find the compromise. Experienced traders know that embarrassing and humiliating moves (market moves down to your Stop, takes you out and reverses) are inevitable. But they keep them to a minimum and therefore when they are stopped out the losses are not so large. If they never get stopped out in a whipsaw move because their stops are very wide, they will be big losers overall because of the expense each time they are stopped out correctly.
There is no rigid formula to calculate how far above or below resistance or support levels you should place your Stop. The margin can sometimes prevent a Stop Loss from being triggered unnecessarily. The margin you apply will depend on the currency pair’s general volatility, the overall market volatility at the time of the trade, and the currency pair’s liquidity.
Tip: You must balance the risk of being take out taken out on a false move with a larger risk that your overall strategy is wrong. You can be flexible up to a point, but you still need to set your ultimate stop loss and then stick to it. This is a key part of your plan.
Establishing your Target
Your trading plan consists of your trade idea, your trade entry price, your initial Stop Loss, your position size decision, your Stop plus management during the trade, and your exit at a target. These should all be decided in advance of the trade and altered as little as possible while the trade is in progress.
Tip: In an ideal world, traders strive for a large reward to risk ratios, 3:1, or even 5:1 trades. But these are only available realistically to swing and intermediate-term traders. Being highly selective means fewer trades. While it’s a good thing to trade infrequently but with high probabilities, you may be left with simply too few trades if you do not have sufficient capital to cover many markets. These high ratios a very rarely found by day traders. The day is simply too short for a big trend to develop. Day-to-day traders and short-term traders are forced into lower ratios. This means the number of profits to loss ratio must be high; otherwise, they will lose money. They are forced into realistic rather than idealistic trades.
Important! Let’s be clear: fundamentals provide no help in this. We can only get our levels to plan our trades using technical analysis.
Focus on technical support and resistance levels as the primary guides for your Entry, Stop and Exit levels. You may look to buy based on a trend line level acting as support, for example, you’re going to be looking at technical resistance above for your profit taking targets. Chart formations, such as channels and flags, Fibonacci levels, trend lines, previous highs and lows, suggest relatively predictable and attainable price targets.
Use momentum indicators like Moving Average Convergence/Divergence (MACD) or Relative Strength Index (RSI) to read the price movement’s underlying speed and momentum. If short-term momentum is accelerating in your trade directions, you can confidently stay with it. You may also consider revising your profit-taking Target to capture an even larger move. After all, if the move is strengthening, why limit the profit? Your risk-reward ratio is improving for the trade. But if short-term momentum in the trade direction is slowing or stalling, consider scaling back your profit Target and adopting a more defensive profit-protecting tactic. For example, raising your Stop-Loss or reducing your position size and, therefore, exposure.
You should be aware of and anticipate upcoming events and market conditions. If you’ve been long for a rally during the North American morning, what is likely to happen when the European markets begin to close for the day? If you are positioned in the USDJPY in the New York afternoon, and Japanese industrial production figures are due to be released in a few hours, what can you expect in the interim? Suppose time indicates the volatility is about to increase. In that case, you may wish to secure the profits you have or protect your position aggressively as the trading conditions are about to change. You had a target for the trade in your plan but you didn’t get there in time.