Marks Investing Blog

Trading in foreign exchange can be risky, especially if you haven’t traded before. Most people who lose money trading in leveraged markets (such as the forex market) do so because they haven’t undertaken the essential learning, , have no trading discipline and no set trading plan. Finding strategies that actually work then preparing a trading plan, takes some research and time to ensure that it covers every essential aspect of keeping your risk capital safe and maximising your chances of success.

Of those who read this, some may ignore it and just jump into trading, eager to begin making money. The odds are very great (something like 20 to one) that those people will end up losing not only the risk capital they have set aside but even more as they try to recoup losses that could have been avoided in the first place.

The essential trading rule is: ‘cut losses, let profits run’. In other words, make sure you quit a losing trade before you lose too much, and make sure a favourable trend is over before getting out. This may involve coming to terms with unexpectedly strong emotional reactions to the inevitable losing trades. Those who begin with the understanding that some trades (and perhaps even a majority at first) will involve losses will stand a better chance than those expect to win on every trade.
Your trading plan should have the following as essential elements:

• Your objective in trading – this may be a target return on risk capital or an expected percentage gain on winning trades. Many traders in forex target a number of pips per week as their trading objective.
• Use of trading strategies that have been proven to work in the past .
• How you will decide when to enter (buy or sell) – this will come from your understanding of proven trading strategies and proper use of technical analysis and chart patterns.
• Use of stop losses – stop losses are essential for risk management, and require close study so that you use them appropriately for your position size and amount at risk.
• How you will decide when to exit, that is, sell back your bought position or buy back a sold one. This is also a result of your understanding of proven trading strategies and proper use of technical analysis and chart patterns.
• Definition of your risk-management system – risk-management rules are designed to preserve your risk capital by limiting the amount you put at risk on any one trade. There’s more to it than this, so find a good course or do some reading on money and risk management before starting.

Money management

Sound money management is essential to the success of your foreign exchange dealing. It’s fundamental. The reason so many potential traders fail early in their attempt is that they ignore this simple discipline that, if followed, will keep any trader from the disastrous losses that often spell the end of their trading endeavours.

Here are some of the guidelines successful traders follow:

1. Don’t risk more than 1 per cent of your capital on any one trade, These rules, along with correct position sizing (see point 3 below) will keep you from risking too much of your capital at once, and from showing a disproportionately large loss on any trade. They work by putting capital preservation ahead of all other priorities. Since you can’t trade without capital, that’s as it should be. At a limit of 1 per cent loss per trade, the maximum number of trades that can be entered at any time is 100.
2. Learn about stop losses and how to use them. A stop-loss order (known as a stop) is an order to exit your position at a particular price as a means of either limiting losses or helping to protect profits already made on positions that are still open. Determine the price level of your stop-loss by reference to the specific currency pair you are trading and its past behaviour, as indicated by charting signals, rather than by simply placing it to keep losses to a known dollar amount. Pay particular attention to support and resistance, trend lines, and recent volatility when placing stops.
3. Know how to calculate your risk-reward ratio, or the ratio of how much you are likely to gain to how much you have at risk. The reward, or possible gain, is based on the target price for the currency, which is the level you expect the exchange rate to reach based on your technical analysis. The risk is the total amount at risk based on where you place your stop, also calculated by reference to chart signals and patterns. Unlike shares, where a minimum risk-reward ratio would be 3:1 – a possible gain of $3 for every $1 risked, the minimum acceptable ratio in the forex market is 1:1. As an example, suppose you expect the Australian dollar to move from $US0.9700 to $US0.9900, a move of 200 pips. Your potential reward is $200 on a mini contract. You set your stop-loss according to your technical analysis based on how far the currency must move before you consider it has turned against the direction of your trade. This might be, say 150 pips, giving you a theoretical maximum loss of $150. Your risk-reward ratio is 200 divided by 150, or 1.3:1, which is acceptable. (The ratio, despite its name, is of reward to risk). The target price, by the way, is not necessarily an exit point but simply the price you expect the currency to reach at a minimum. Depending on your strategy, the exit criteria could be separate from the target price and allow for the possibility that the target may be exceeded.
4. Determine your position size (number of contracts to buy or sell of what size) based on how much you will lose if the stop is triggered at the indicated level, and the 1 per cent rule. You should know in advance how much the likely maximum loss will be on the trade. In practice, if your capital is $50,000, your maxim allowable loss is $500 on any trade. Suppose you determine that your stop-loss should be placed 120 pips below the current level for an AUD/USD trade (Australian dollars valued in US dollars). If you trade a mini contract size of $A10,000, 120 pips is equivalent to $A120 of profit or loss. Divide this into your maximum allowable loss of $500 and your position size is a maximum of four contracts, with a likely maximum loss of $A480, which is within your limit. Don’t ever forget that if your change your stop-loss price level, you must adjust your position size accordingly, especially if it takes you over the limit of your maximum allowable loss. A tighter stop-loss reduces total risk and may indicate a larger position size.
5. Realise that no matter how well you know the rules, emotion can step in and overrule that rational knowledge. Hesitation through uncertainty before entering a trade, and the tendency to hold on to a losing position in the hope that it will turn around and prove you right, are among the most common trading errors. The only rational response to a loss on any trade of more than the 1 per cent allowed is to exit, re-entering if the market does turn in the other direction. The only rational response to a profit is to hold the position until the market has clearly turned.

Trading psychology

The psychology of trading relates to how well a trader manages his trading capital and the risks involved in leveraged trading. The only successful traders are those who keep strictly to the money management rules that have been found to work. The psychology of trading examines why there is a conflict, if any, between what we think and understand about the markets and what we go on to do. The reason traders – especially beginners – don’t follow the rules is that they have not understood their own relationship to money and to greed. Leveraged trading in forex will challenge you to know yourself better and to learn what you really think about money and greed. It will also challenge you to accept responsibility for your results in the knowledge that there is no-one else to blame.

There is no substitute for experience in learning about your own ability to keep from overtrading, hesitating, risking too much, from adjusting stop-loss levels without sound reasons or from holding a losing position past the maximum loss level. But awareness of these possibilities and the reasons for them in your own mind – everyone being different in this regard – can make the experience more valuable. A good place to start is Mark Douglas’s book, Trading in the Zone, which is written for traders generally and is directly applicable to forex trading.

Data and software

To know whether the entry and exit rules in your trading plan will work, you will need to test them on actual trading data. The best way to do this is through software designed for the purpose using past data from actual foreign exchange markets. Your forex provider may be able to help you with a practice account that includes many of the tools you’ll need, or an internet search will help you track down the appropriate tools. Only when you are confident your system will work – providing bigger profits on winning trades over time than the losses on losing trades – should you begin trading with real money.

Usually more reliable than data from forex providers is that from third parties, which you can find by conducting an internet search for top financial data vendors and trading software firms. In this area it’s a pretty good guide that you get what you pay for, and reliable data improves your analysis. Data providers also offer accompanying software, but software firms don’t always offer the accompanying data.

Need to know

• The golden rule of speculative trading is to cut your losses (quickly exit from losing trades) and let profits run (stay in the trade until the market changes direction).
• Every successful trader has a trading plan setting out objectives, the entry and exit signals to be used, and risk and money management parameters.
• Confidence is key. You need to know that the chart signals you use, combined with your money management regime, can provide profits that outweigh losses over time.

Thank you to Knowledge to Action for providing this information.