What Makes a Trading Method Sound? Continued
June 21st, 2009
Forex Trading Techniques : What makes a trading method “good”?
Risk Management : I need to continue the debate on a way to find the right trading technique for Forex trading. Formerly , I shared that for any Forex trading method to be considered, it has to be a total methodology ( insert link to prior article ) .
Today, I need to add to that by talking about risk management. This is perhaps the area where 95% of Forex traders make mistakes and lose money. Managing risk is about reducing your losses AND about protecting trade capital by employing specific strategies to accomplish each of these simultaneously.
What do I mean by that and why is it important?
First, most Forex traders make simple trading mistakes: they take too large of a position and expose themselves to serious and steep losses should the markets move against them. 2nd , they fail to guard their Complete account by permitting ONE trade to put their full account balance at risk.
Here’s a fast and maybe extraordinary example:
Suppose a forex trader has a $10,000 account balance. The currency exchange trader takes a five standard lot foreign exchange trade on the EUR/USD pair. The currency exchange trader now has at least $5,000 ‘margin’ at risk ( or fifty percent or more of the foreign exchange trader ‘s account balance ).
For each one point that this currency exchange trade moves against the foreign exchange trader , the trader loses 1/2% of the total account balance. Find out more see my Forex Income Engine 2. At first peek, that might not seem to be a steep loss. However, should the Forex trade move a total of fifty pips against the Forex trader , and the trader afterwards exits the position, the foreign exchange trader ‘s total loss would be an Fantastic $2,500! ( 25% of the trader’s account balance ). This is poor risk management and it often leads to finish wipeouts of Forex trading accounts.
How did we work out that loss? One pip for the EUR/USD pair is the same as $10 ( on the standard lot trade ). A fifty pip loss equals a financial loss of $500 ; and remember our example currency exchange trader had traded five standard lots — for a gigantic loss of $2,500!
Instead, any trading technique should teach you highly specific rules for incorporating money management and risk management into each foreign exchange trade you take. Find out more read this Forex Income Engine 2 Report.
Money Management should involve the distribution of a currency exchange account among the assorted trades a foreign exchange trader takes. For example, forex traders should never trade their entire account on a single trade, and should rarely have more than a few open positions. By employing multiple positions, the foreign exchange trader distributes the danger among each one of the foreign exchange trades they have taken.
Risk management should involve the maximum risk in any SINGLE Forex trade, and should limit the impact of a losing Forex trade on the trader ‘s account balance.
Here are 2 fast examples:
Money Management : A unproven currency exchange trader takes four separate one lot trades on 4 separate pairs. Assuming here that each of the pairs have a pip value of $10 on a standard lot, then the total amount of the account being margined across all four trades is about 40% (it may be higher depending upon the actual pairs traded. With correct stop loss management in association with risk management, it is Doubtful the currency exchange trader would attract a complete 40% loss.
Carrying forward to chance management : In each one of the unproven currency exchange trades above, the foreign exchange trader risks only 2% of the trader ‘s total account balance on each foreign exchange trade. That means a maximum loss of $200 per forex pair traded if ALL FOUR trades are stopped out. Total loss in this case would be $800 — a much more recoverable scenario than the $2500 in the first forex trade example.
Furthermore, Risk Management has the capacity to make loss recovery easier. As an example, in the 1st case, where the Forex trader lost $2500, the trader would need a virtually 250% gain on their next trade to recover the lost value on the 1st trade.
In the 2nd example the foreign exchange trader would need only an 8% gain.
A 2nd part of Risk Management not generally debated in poor trading strategies is defending gains. Though this starts as a consultation on Exit Methodology rules, it’s also a factor of risk management. Once a currency exchange trade turns profitable, it is urgent the currency exchange trader manage the gains with smart stop loss management. The worst thing a foreign exchange trader can do is permit a lucrative position to reverse and become a losing position. Thus, managing risk extends to the protection of gains on a forex trade, just as it does protecting against deep losses on a forex trade.
Therefore, in considering any trading method for use in your Forex trading, you must ensure that risk management is not only discussed, but clearly explained in conjunction with the use of the trading method. If risk management isn’t present, confusing, or not particular to the trading technique, you need to avoid using that trading method. For additional see this Forex Income Engine 2.
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