3 Tips to Better Risk Management

While the question of money management may seem fairly straightforward, it remains the most critical component of any trading plan. Before placing a trade, traders should examine exactly what the risks associated with that trade. This includes asking some tough questions about stop placements, risk totals, as well as risk reward levels. To help answer some of these concerns today we will tackle some tips for better risk management. Let’s get started!

 

Plan Your Exit

More often than not, traders have an idea of where to exit the market when a trade is moving in their favor. While a profit target is always good to have, every trader should have a contingency for when a trade moves against them. Stop losses can be set in a variety of manners, but more often than not these levels are coupled with an existing value of support and resistance.

Remember, a stop order is a point on the graph where your trade idea is considered no longer valid. If you have buy orders in place, and a key level of support is broken with price making a lower low it may be time to consider exiting the trade. As well, the opposite is true in a downtrend. If a trader is selling while prices are making higher highs it may be time to look for a new trading idea!

 

The 1% Rule

After you have planned a point of exit, traders need to decide how much to risk per trade. Since it is inevitable that at one point a trade will close at a loss, it is important to know exactly how much you intend to lose prior to that occurring. One way to determine this is the 1% rule. Simply put, this means traders should risk no more than 1% of their TOTAL balance on any one trade idea. For instance if you have a $10,000 balance at no point would you want to risk more than $100 on any 1 trading idea.

The 1% rule can also be coupled with a favorable risk reward ratio. Using a 1:2 setting, this means if we risk 1% in the event of a loss, at minimum we should look to close our trades out for a 2% profit. This would translate into a $200 profit on a $10,000 account balance. Now that you are familiar with the 1% rule, let’s look at our next risk management tip.

 

FXCM Money Management App

To help traders control and manage their risk, programmers at FXCM have created a simple indicator to help decipher how much risk is being assumed on any one particular trade. Once added to Marketscope 2.0, the FXCM Risk Calculator, as depicted above, has the ability to help a trader calculate risk based off of trade size and stop levels.

We walk through the application, as well as how to manage risk in several videos embedded into the brainshark medium. After clicking on the link below, you’ll be asked to input information into the ‘Guestbook,’ after which you’ll be met with a series of risk management videos along with download instructions for the application.

Risk Management App Download and Review via Brainshark

Becoming an Emotionally Intelligent Trader

We’re only in it for the money. That key trading concept is obvious but shouldn’t be forgotten. The reason why this mantra is key is because we’re not into trading for the following reasons:

-To Beat the Market

-To Show People How Smart You Are

-To Feel Excitement through use of Aggressive Leverage

If you’re interested in learning what else, besides emotions, it takes to trade like a professional trader, register for our free course here.

 

Why Emotions Get Shunned By Traders

Some traders opt for an Automated Trading or Black Box strategy. The purpose of a black-box system is to have your preferred trading rules or edge programmed so as to put you into a trade and exit you from a trade when the edge is gone or the profit target is achieved. The argument of this approach is that your emotions can’t get in the way of you entering or exiting a trade. However, a trading career is made up of more than just on trade and if you do not have the emotional strength to stick with your edge, programmer or discretionary, then your emotions are still getting the best of you.

Either way, your emotions are at play. If you’re deciding when to enter the trade yourself, known as discretionary trading, your emotions are obviously at play. The way emotions effect newer traders is that new traders hope their losses will come back so they let them run in order to avoid booking a loss. They fear that their profits will turn into losses so they cut them short. However, this fear and hope tug-of-war doesn’t work out in the traders favor in the long term.

 

A Better Way to Look at Emotions

Emotions aren’t bad if you know how to steer them towards your benefit. By default, you likely don’t like being wrong or losing money, who would? However, taking a big picture view, being wrong sometimes and losing a little money when deciding if the market is going to move in the direction you believe it will, these two things aren’t that bad and are in fact, inevitable.

So a better way to look at emotions is to flip how you’re using hope and fear and most specifically fear. If you can switch your fear from a place of fearing a losing to trade to fearing a losing trade getting out of control, you’ll discover a key emotional truth to trading well, regardless of your balance.

As the opening quote mentions, instead of hoping that your loss will turn into a profit so you don’t look like a failure, you should hope that your profits grow larger while always fearing a large relative loss. By flipping these from there default function, you’re no longer holding onto a losing trading waiting for it to come back while closing out your good trades at a minimal profit afraid that the profit will slip through your fingers. As Michael Martin put it, that’s like pulling your flowers and letting your weeds flourish in hoping they change. 

 

Applying Your Emotions to FX Trading Appropriately

 

 

So now that you know that your emotions are not your enemy when appropriately adjusted, what’s the best way to apply this information? This may come as a shock, but you need to start from the premise that you don’t know FOR SURE if your next trade will hit its protective stop or profit target. Of course, you’d prefer that every trade hit its profit target but by now, you know that’s not always the case.

However, like the picture from above, you’re not sure if the next trade will take you off the road you were planning on driving down (read: the trend bends or ends to get you out of your trade). Therefore, when you’re in a trade based on your edge or indicators, it’s best to keep an eye for trades that go against you from the start and see that it’s best to fear these trades and get out there or just accept that your profit target most likely will not get hit but whatever you do, don’t remove your stop and hope for a trade that goes sour right away. These are the trades you should rightly fear draining your equity.

On the flip side, if you’re entering at the right time and price (unbeknownst to you or not), and the trade goes in your favor right away, then it’s best to keep the hope in play that this could be a big move that makes your day, week, month, or year and move your stop up to break even when your system sees it appropriate.

I’ll leave you with a quote from Michael Martin that’s been helpful for me and I hope it does the same for you. “Winners never quit, but quitters have more equity in their accounts when they admit defeat and return tomorrow with a fresh start and a clear head.” This world of trading is a paradox, the trading paradox involves embracing losing trades early and often while allowing those few golden trades make your year.

Now that you're familiar with a new way of handling emotions while trading, feel free to try this information out on a FREE Forex Demo Account with access to multiple markets.

New Traders Beware

In today’s day and age of high speed computers, lighting fast financial information, and data overload, diving into the world of trading can be a frightening challenge for a newcomer to say the least. Add on top of that deciding which strategy to use and it’s no wonder why so many traders fail. You can choose the path of fundamental analysis where you will focus on economic and financial reports to make decisions. You can focus on conventional technical analysis which is loaded with price patterns, indicators, and oscillators, and more. Maybe you want to combine the two like some people do and spend 23.5 hours a day crunching data and looking at charts and about 30 minutes for eating and sleeping. An alternative approach to trading may be something you are already very good at, properly buying and selling anything. Let’s take a look at the various ways people attempt to trade the markets, including the core strategy we employ at Online Trading Academy. Let’s explore these to simply figure out what makes sense.
During a live online trading session from last week in the XLT (Extended Learning Track), we setup some trades for our students. The screen you see below is one of two that begins all of our trading sessions where we lay out the entire trade for students. It was a buying opportunity in a stock, EMC.



The trade was to buy EMC at 24.94 with a protective sell stop at 24.81 and a target at 25.40 and 25.77. The demand level we were planning on buying at is shaded in yellow. I assume there is more demand than supply at that price level because price could not stay at that level and rallied. I know that this can only happen because demand exceeds supply at that level. Another word for demand is “wholesale.” So, if I am a smart buyer and seller of anything, I know that when prices are at wholesale levels, I want to buy from someone who desires to sell at wholesale levels. Isn’t that how every business makes money?

The EMC Demand Zone


 
Live Trading Session – EMC Returns to Demand: Time to Buy



During the trading session, the trade met entry as price declined into that level. What that meant was that someone was convinced that EMC was worth selling at our wholesale price which meant we wanted to buy. Shortly after meeting entry, price rallied and met our two profit targets for a nice low risk gain. Our simple rule based strategy has us buying at price levels where demand exceeds supply (wholesale prices) and selling at price levels where supply exceeds demand (retail prices). This may sound as too simple and boring but that’s the way I choose to do it. Let’s take a look at some alternative ways of trading and in doing this, let’s look at the same trade through the eyes of conventional technical analysis with indicators and oscillators and such.
The charts below are the same two charts with the same trade only I have added some popular indicators and oscillators to it. With all this added information on the chart, you would think that we are able to make a smarter trading decision but think again. First of all, the hardest thing to see on the chart are the candles and that is the most important piece of information for me (obviously not for the conventional T/A trader). The reason why I believe none of these things I have added to the chart help a trader is because they all lag price. They will simply do what price has already done. This means that if we add any of these indicators to our core decision making process, we are simply adding risk and decreasing reward. The goal is low risk entries and big profit margins. Notice all the moving averages on the chart. Most people will only buy when they are sloping up. Notice that when price declined into our demand zone and it was time for us to buy, the moving averages were all sloping down. This will always be the case which is why conventional T/A traders always miss the low risk entry.



Next, notice all the other squiggly lines on the chart, they actually would have hurt us with losses and high risk entries. And, what about ATR, Average True Range (ATR). I have absolutely no use for this and feel bad wasting time writing about it but I will for your benefit if you’re trying to make this work. ATR shows you an average of the prior ranges in price. The thought is that this will tell you what future ranges will be to potentially help with risk management. But what if I gave you a choice and said I could teach you how to use conventional ATR which looks at ranges in the past or I could teach you how to identify what the future range will be, what would you want to learn? I am sure your saying “future” ranges as that is the key information we all want to know, I agree. Well, if you want to know what the range in the near future is going to be, measure the distance between a markets “fresh” demand and supply levels. If they are far apart, the range is “going to be” large. If they are close to each other in price, the range is “going to be” small.
As I have said before, you can learn the book version of trading if you want to but make sure you find plenty of people making money from reading the books first. Or, you can learn to trade by focusing on the reality of how markets work and how money is really made and lost in markets. This means quantifying real demand and supply in a market and then buying low and selling high, just like you do in every other part of life. Simplicity is the key for us in XLT.

Taking Advantage of Missed Breakout Opportunities

Breakout trading is often associated with quick decision making and fast paced entries and exits, but it doesn’t have to be that way. Often times there are opportunities to get into a breakout trade well after the initial break. On top of that, there can be opportunities to enter into a breakout trade at a better price than what was originally presented. Today, we will discuss how to take advantage of missed breakout opportunities.

 

The Recent GBPUSD Breakout

The long term GBPUSD price chart is a prime example of a major breakout. We recently witnessed “cable” breaking to a multi-year high followed by a near-50 pip rally to breakout traders’ delight. If you were one of those breakout traders that participated, congrats. It was a good trade and I am happy it worked out for you. For the others that missed the break, don’t sweat it. These breakouts sometimes yield an opportunity to get in well after the initial break. Let’s take a look.

 

Trading the Breakout Pullback

In order to qualify as a breakout, price must break through a support or resistance level. (Do you understand these terms? Test your knowledge by taking our Technical Analysis Quiz). But after this break occurs, price sometimes will pullback to the support/resistance level that was originally broken. The old saying, “What once was support, can later become resistance (and vice versa)” applies to this situation. Price can bounce off this level and produce a trading opportunity.

In the case for the current GBPUSD breakout, we’ve seen exactly this. Two days after the initial break, price has returned to its prior resistance level, giving us a buying opportunity. Our trade idea is based on the idea that this resistance level will now act as support. This scenario can be seen in the image below.

 

Learn Forex: GBPUSD Pulling Back to Support After Breaking to a Multi-Year High

(Created using Marketscope 2.0 charting package)

 

So the initial break of the resistance area occurred two days ago, followed by another bullish blue candle. Today, GBPUSD fell heavily back towards the resistance area which now could act as support. This gives a buying opportunity (marked with a highlighted circle on the chart above) that actually gives us a better price to enter than the original breakout candle’s closing price.

 

Breakout Pullback Exit Plan

To exit this trade, we recommend using a 1:2 risk:reward ratio with a stop loss below the support/resistance area (around 1.6770) and a limit at least twice as far (around 1.6990). This will put our stop beyond the next closest support level and our limit underneath the psychological 1.7000 level. These orders should both reduce our risk and maximize our potential return from the trade. If you would like to explore other ways to exit this trade, check out my 3 Basic Ways to Exit Your Forex Trades.

 

Second Time’s a Charm

So next time we see a break out that we missed, know that it’s not a big deal. If we can be patient and wait for a pullback to the original support/resistance level, we can still get into the trade and possibly get in at a better price than what was originally available. This technique combined with a well thought-out exit strategy is worth testing using an FXCM demo account.

Why Traders Lose Money

While the title of this article can have broad implications with numerous explanations, we’re going to do our best to reduce the answer to this query to the most logical and basic explanation.

When a trader first gets started, it might be hard to imagine how getting control of losses can seem an impossible task. It may even feel like the cards are stacked against you… situations in which you’re right in your analysis, yet you still lose on the trade and watch capital disappear from your trading account.

So, a natural question is why some traders consistently make money while others lose, even when they’re right. That is what we will be investigating in this article.

The Difference between Trading and Analysis

Many new traders come to the market with a bias or point-of-view. Perhaps this is built from a background in economics, or finance, or maybe just a keen interest in politics. But one of the biggest mistakes a trader can make is harboring the expectation that ‘the market is wrong and prices have to come back.’

But let’s face it: Markets are unpredictable, and it doesn’t matter what type of analysis you use. As new information comes into the market, traders and market makers price it accordingly; because these folks don’t want to lose money just as much as you don’t want to lose money.

Is this to say that analysis is worthless? Absolutely not: It merely means that analysis is only a part of the equation of being a successful trader. Analysis is a way to potentially get the probabilities on the trader’s side, even if just a by a little bit; a way to maybe get a 51% or 52% chance of success as opposed to a straight-up coin flip.

Good analysis, whether it be fundamentally-driven or technically-driven, can be right a majority of the time. But no form of analysis will ever be right all of the time. And this is the reason that there is such a large chasm between analysis and trading.

In analysis, it doesn’t matter how wrong you are when you aren’t right. In trading, this matters quite a bit. Because even if you’re winning on 70% of your trades, if you’re losing $3 for every trade in which you’re wrong but only making $1 every time that you’re right, you’re still losing. It might feel good, because 70% of the time you’re walking away from your positions with the feeling of success; and as human beings this is something we generally strive for (to feel good).

The example below shows how bad risk management can destroy even a strong winning percentage of 70% success.

But logically, it doesn’t make sense to embark on this type of endeavor because the goal of trading is to make money; not necessarily to just ‘be right’ more than 50% of the time.

How to actually trade analysis

First thing first, traders need to crystallize what their actual goal is in trading in markets; and point-blank, that goal should be to make money.

After that, traders need to expect that they will, at times, be wrong.

So given these two facts, the next logical assumption is that without being able to control the damage from those instances in which we’re wrong, the prospect of profitability is a distant one.

So risk management isn’t just a preference or a style of trading: It’s a necessity for long-term profitability. Because even if you’re winning 90% of the time, the losses on the other 10% can far outstrip the gains that are made on the 90%.

I fully realize this isn’t necessarily exciting information. When I teach risk management, rarely do a see a student-trader ready to burst out of their seats to go and manage some risk. Most people want to hear about entry strategies, and analytical methods to try to get those odds of success tilted even higher in their favors.

But until a trader learns to manage their risk, much of this additional work is a moot point. Because as long as the risk exists that one bad position can and will wipe away the gain from many other ‘good’ positions; that trader is going to struggle to find profitability.

So, to properly trade analysis one needs to first observe proper risk management. Because trading isn’t just ‘guessing’ and ‘hoping’ that we get it right. Profitable trading is implementing analysis while properly managing risk factors; implementing a defensive approach so that when one is wrong, the losses can be mitigated and when one is right, profits can be maximized.

How can one begin to use ‘proper’ risk management?

We’ve already encountered one of the biggest mistakes of risk management, and that’s controlling the size of the losses relative to the size of the gains.

This was listed as The Number One Mistake that Forex Traders Make, and in the article The Top Trading Mistake, we looked at exactly how this problem can be so utterly damaging to new traders.

The solution is simple; implementing it not as much. As human beings, we often follow our gut instincts or our ‘feelings.’ But in trading, we have to keep the bigger picture in mind. When we place a trade, we often try to win on that one trade. This can keep traders holding on to losers for far too long, and closing out winners way too quickly.

Traders can adjust strategies to focus on lower-risk, higher reward types of setups

Image taken from How to Identify Positive Risk-Reward Ratios with Price Action; by James Stanley

The way to fix the Top Trading Mistake is to simply look to make more when you’re right than you lose when you’re wrong. That’s it. This can be done by setting stops and limits on every trade that is placed to reinforce that minimum 1-to-1 risk-to-reward ratio.

Unfortunately, risk management isn’t as simple as just setting a stop and setting a limit. After all, if a trader takes on a position that’s way too large relative to the size of their account, even if using a 1-to-2 or 1-to-3 risk to reward ratio; that one trade could completely wipe them out.

This is similar to the advice of ‘not putting all of your eggs in one basket.’ And while this concept is simple for equity investors that have seen stock prices fall off-of-a-cliff, highlighting the fact that investing in just one stock can be so dangerous, traders should look at the art of speculation in a similar light.

We discussed this topic in the article, Top Trading Mistakes, Part II: The impact of larger amounts of leverage. Not only does high leverage bring on a higher potential for failure, but highly-leveraged trades also amplify The Number One Mistake Forex Traders Make because more leverage amounts to even bigger swings in account equity.

We finished off the Top Trading Mistakes series with the third article, and this comes down to strategy selection. Even if a trader goes out of their way to prevent the top two trading mistakes, it doesn’t guarantee success. Holy Grail strategies don’t exist, and the best that a trader can do is to look to employ an approach befitting of that particular market’s condition.

If you’d like an example of how this can be done, the article How to Catch Swings in the Forex Marketshowed how traders can look to trade short-term reversals or swings with a constant eye on risk management.

How to Match Your Personality with Your Forex Trading Strategy

If you’re having trouble sticking to your forex strategy, then you might need to figure out if your personality matches your trading style. In his book, “Mechanical Trading Systems: Pairing Trader Psychology with Technical Analysis,” author Richard Weissman identifies three basic trader personality profiles: trend-following, mean-reversion, and day-trading types.


Are you a trend-following trader?

Weissman enumerates two traits necessary for successful trend-followers: patience and fortitude. Trend-following mechanical systems attempt to catch strong directional moves, with signals forming when the trend has already begun. A typical entry strategy may be to buy at recent highs or sell at recent lows, in anticipation that the price will make a new high or low later on. This may seem counter-intuitive to the majority of traders who like to pick “tops” and “bottoms,” but that’s what sets trend-followers apart from the rest.

The strength of this method is that if you catch a strong trend, you can come up with huge winning trades relative to your initial risk. But of course, no system is fool proof and there are tradeoffs to grabbing potentially big wins.

As the saying goes, “markets range 70-80% of the time.” That means catching a strong trend can be rare, and sticking to a trend-following system requires that you endure several small losses when your entry signals have you jumping in when the market consolidates or pulls back.

To be a trend-following trader you must be comfortable with potentially having a low win ratio, but as long as your winning trades generate enough profits to outpace your losses, then that’s all that matters.

So the questions you have to ask yourself are: Do I have the mental fortitude to handle more losses than wins? Do have the patience to ride the winning trades to their full profit potential? If you answered “yes” to both questions or if you feel stressed having to come up with numerous trade decisions in a day, then trend-following mechanical systems may be the right entry/exit method for you.

Are you a mean reversion trader?

In terms of price action, the mean reversion theory states that on average, markets are more often trading within a range than trend. When the market goes beyond its average range of historical volatility, it tends to fall back to the middle of that range, or the “mean.” These systems aim to look for probable reversal points (i.e. tops and bottoms) where price movement could change direction.

The major difference is that while trend following systems aim to “ride the trend” for large profits, mean reversion systems normally have an exit in mind based off key support or resistance levels. This means a lot more smaller winning trades.

A couple of indicators used in mean reversion systems are the ADX and Stochastic. The ADX helps identify whether the market is in a trend or rangebound, while the Stochastic indicates potential overbought and oversold conditions that tend to precede a reversal.

The key to utilizing a mean reversion system, especially during the long-term timeframes, is maintaining rock solid discipline. Using this method could put you in the market against a strong trend, which can be psychologically difficult if it doesn’t turn your way. Also, there can be many distractions and obstacles that cause psychological stress for a trader, such as the media and other traders. You must train yourself to follow your system’s rules no matter what and remember that the strength of a mean reversion system is the high probability that markets will stay in a range.

Are you a day trader?

Lastly, we have day trading systems. These can be trending or mean reversion systems, but on a shorter time frame–Weissman cites that these generate signals for trades that last 10 days or less. Market junkies who have a knack for these kinds of fast-paced systems usually look at the hourly time frame or lower to aim for smaller profits and place tight stop losses.

According to Weissman, mechanical systems benefit short-term traders the most as the frequency of making trade decisions arise. By using a mechanical system that already outlines what entry and exit levels to take with pre-determined risk-reward ratios, a day trader is somehow relieved from stress.

However, this is not to say that intraday systems are all sugar, spice, and everything nice. The biggest drawdown to using them is that they are labor-intensive. Traders have to be glued to their screens during trading hours either to be ready to act on valid signals or to monitor/adjust their trades.

Dealing with potentially volatile intraday market action, a trader must be able to quickly make sound decisions. Mental agility is critical for someone to master day trading systems and if you think that you have the capacity to find Zen amid the chaos, you may want to try out an intraday system.

So what’s your trading personality?

You have to remember that regardless of what kind of system you’re using, the market will always find a way to put you between a rock and a hard place. There will be times that you will have more losers than winners, trades go quickly against you, or you’ll have to let go of some of your unrealized profits, but knowing what you are comfortable with and finding the system or method that matches your personality will help you better adapt to the always-changing market environment.

Check out our trading personality quizzes (No, we did not pull these off Cosmo! Only Big Pippin reads that, but don’t tell him I told you his little secret!) to figure out if your personality matches your trading strategy.

10 Things I Focus On As A Trader

One of the best things a trader can have is a filter that allows them to see what matters and what does not. Knowing where to focus our effort and time at to be a profitable trader is crucial. Some things will make us money and some things will cost us a lot of money and divert our attention from what does matter. Here are the 10 things I focus my time, energy, and attention to primarily:

1. I focus on what the current price action in the markets may be telling me based on support, resistance, gaps, moving averages, and a few technical indicators.
   
2. I study how price action played out on historical charts of the stock market in relation to my above indicators.
   
3. I spend a lot of time back testing trading systems that I have a theory about to see how they would have worked.
   
4. I develop entry signals off my studies so I have a good risk/reward ratio and a good probability of a profitable trade.
   
5. I focus on what my stop loss level will be before I get into a trade so I know how big to trade without losing too much trading capital.
   
6. I develop ways to exit my trades to lock in maximum profits and limit potential losses if wrong.
   
7. I find and read the best trading books I can buy based on others recommendations and Amazon reviews. I want books written by real traders not just writers or people with theories.
   
8. I hang out with some really good traders in a few facebook trading groups that have more experience than I do and I learn a lot from them.
   
9. I focus on following my trading system with discipline and not letting my emotions or ego interfere with making the right decisions.
   
   
10. I use the internet and social media to learn by finding the best information based on facts not opinions.