Education to help you become a more confident trader
Risk Management
Guide to Forex Trading
Risk Management Basics
There are three basic questions that every trader should answer BEFORE entering a trade.
1. How much do I believe the market will move and where do I want to take my profit?
Limit Orders allow traders to exit the market at profit targets. If you are short (sold) the system will only allow you to place a Limit Order below the current market price because this is the profit zone. Similarly, if you are long (bought) the system will only allow you to place a limit order above the current market price. Limit orders help create a disciplined trading methodology and enables traders to walk away from the computer without constantly monitoring the market.
2. How much am I willing to lose before I exit the position?
A stop/Loss order allows traders to set an exit point for a losing trade. If you are short a currency pair the stop loss order should be placed above the current market price. If you are long the currency pair the stop loss order should be placed below the current market price. Stop/Loss orders help traders control risk by capping losses. Stop/Loss orders are counter-intuitive because you do not want them to be hit; however, you will be happy that you placed them! When logic dictates, you can control greed.
3. Where should I place my stop and limit orders?
As a general rule of thumb traders should set Stop Orders closer to the opening price than limit orders. If this rule is followed, a trader needs to be right less than 50% of the time to be profitable. For example, a trader that uses a 30 pip Stop/Loss and 100 pip limit orders needs only to be right 1/3 of the time to make a profit. The trader's risk-adversity will determine where the trader places the stop and limit. Stop/Loss orders should not be so tight that normal market volatility knocks the position out. Similarly, Limit Orders should reflect realistic expectation of gains given the markets trading activity and the length of time one wants to hold the position.
What should the psychology of the trader be?
Before placing trades, traders must sufficiently analyze the position they are about to take. However, many do not thoroughly plan out their actions, and instead make trades based on guesses and hunches. This psychological viewpoint can result in traders losing a lot of money very fast. How can this be avoided? Through careful planning and analyses, including where to place stop and limit orders, a trader can keep losses to a minimum while allowing profits to run.
Make sure to have a plan that utilizes stop and limit levels before making the trade in order to minimize losses and lock in on profits.
One huge psychological error that many traders make is going against their original plan and either closing positions to take a profit before they reach the profit target or not closing a losing position in the hopes that the market will come back in their favor. Another psychological error traders make is to believe that every trade should be profitable. If there is an instance where a stop is hit and then the market goes back in favor of the position the trader had held, this belief can cause the trader to remove stops from their trades.
What is often forgotten is that stops are there to keep them from losing more money than they would like; not to be some sort of roadblock against profit. It is okay to hit stops and lose the pre-determined amount of money because when a trader lets profitable trades run, the loss will be made up for and more. Do not try to improvise. Stick with the original plan and precautions made before the trade.
Another psychological error traders make is becoming too committed to a trade and unwilling to let it go. A trader must keep his original analysis in mind when seeing the result of a trade, and be objective about what is happening to his position and what he should do about it. However, many traders attempt to analyze the position differently from the original analysis so that the analysis will favor their original position. They intentionally distort their analysis for one of two reasons: they do not want to close the position with a loss or they are hoping that the position will become more profitable than it already is.
This psychological viewpoint causes many traders to lose the profit that they had made or lose more than they originally would have lost. Just because leverage is provided does not mean it is okay to trade large portions of the account at a time or too frequently. A prevalent mistake made by many traders is overtrading, meaning that they trade much larger amounts of their account than is reasonable or trade too frequently. Although leverage allows traders to trade one lot of currency with only $20 as a margin deposit, it does not mean that traders should trade their entire available margin in one or two trades. Please keep in mind that without proper risk management, currency trading has a high degree of leverage which can lead to large losses as well as gains.
The psychological mistake they are making is that they are thinking of their trade as a $20 investment, when in actuality it is a $1,000 investment. Although most traders perform adequate analysis of currencies before placing trades, they sometimes use too much of their margin and are later forced to exit the position at the wrong time. A general rule that traders try to follow in order to keep themselves from getting over-leveraged is never risk more than 5% of their accounts equity at any given time. This means less than 10% of your margin should be used margin at any given time.