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Risk Management
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Although risk management is one of the simpler topics to grasp, it seems to be the hardest to follow for most traders. Too often we have seen traders turn winning positions into losing positions and solid strategies result in losses instead of profits. Regardless of how intelligent and knowledgeable traders may be about the markets, their own psychology-will cause them to lose money. What could be the cause of this? Are the markets really so enigmatic that few can profit? Or is there simply a common mistake that many traders are prone to make? The answer is the latter. And the good news is that the problem, while it can be an emotionally and psychologically challenging one, is ultimately fairly easy to grasp and solve.

Most traders lose money simply because they have no understanding of or place no importance on rink management. Risk management in­volves essentially knowing how much you are willing to risk and how much you are looking to gain. Without a sense of risk management, most traders simply hold on to losing positions for an extremely long amount of time, but take profits on winning positions far too prematurely. The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning positions than losing ones, but ends up with a negative profit/loss (P/L). So, what can traders do to ensure they have solid risk management habits? There are a few key guidelines that all traders, regardless of their strategy or what they are trading, should keep in mind.

Risk-Reward Ratio

Traders should look to establish a risk-reward ratio for every trade they place. In other words, they should have an idea of how much they are will­ing to lose, and how much they are looking to gain. Generally, the risk-reward ratio should beat least 1:2, if not more. Having a solid risk-reward ratio can prevent traders from entering positions that ultimately are not worth the risk.

Stop-Loss Orders

Traders should also employ stop-loss orders as a way of specifying the maximum loss they are willing to accept. By using stop-loss orders, traders can avoid the common predicament of being in a scenario where they have many winning trades but a single loss large enough to eliminate any trace of profitability in the account. Trailing stops to lock in profits are particularly useful. A good habit of more successful traders is to employ the rule of moving your stop to break even as soon as your position has profited by the same amount that you initially risked through the stop or­der. At the same time, some traders may also choose to close a portion of their position.

For those looking to add to a winning position or go with a trend, the best strategy is to treat the new transaction as if it were a new trade of its own, independent of the winning position. If you are going to add to a win­ning position, perform the same analysis of the chart that you would if you had no position at all. If a trade continues to go in your favor, you can also close out part of the position while trailing your stop higher on the re­maining lots that you are holding. Try thinking about your risk and reward on each separate lot that you have bought if they are at different entry points as well. If you buy a second lot 50 pips above your first entry point, don't use the same stop price on both, but manage the risk on the second lot independently from the first.

Using Stop-Loss Orders to Manage Risk Given the importance of money management to successful trading, using the stop-loss order is im­perative for any trader looking to succeed in the currency market. The stop-loss order allows traders to specify the maximum loss they are will­ing to accept on any given trade. If the market reaches the rate the trader specifies in his/her stop-loss order, then the trade will be closed immedi­ately. As a result, using stop-loss orders allows you to know how much you are risking at the time you enter the trade.

There are two parts to successfully using a slop-loss order (1) ini­tially placing the stop at a reasonable level and ( 2) trailing the stop—meaning moving it forward toward profitability—as the trade progresses in your favor.

Placing the Stop-Loss There are two recommended ways of placing a stop-loss order.

Two-Day Low Method These volatility-based slops involve placing your stop-loss order approximately 10 pips below the two-day low of the pair. For example, if the low on the EUR/USD's most recent candle: was 1.1200 and the previous candle's low was 1.1100, then the stop should be placed around 1.1090—10 pips below the two-day low—if a trader is look­ing to get long.

Parabolic Stop and Reversal (SAR) Another form of volatility-based stop is the parabolic SAR, an indicator that is found on many currency trading charting applications. The FX Power Charts, for instance, offer this indicator, freely available to all course subscribers (www.fxcm.com). Parabolic SAR is a volatility-based indicator that graphically displays a small dot at the point on the chart where the stop should be placed. Figure 7.3 is an example of a chart with parabolic SAR placed on it.

There is no magic formula that works best in every situation, but the following is an example of how these stops could be used. Upon entering a long position, determine where support is and place a stop 20 pips be­low support. For example, let's say this is 60 pips below the entry point.

If the trade earns a profit of 60 pips, close half of the position in a mar­ket order, then move the stop up to the entry point. At this time, trail the stop 60 pips behind the moving market price. If the parabolic SAR move's up so that it is above the entry point, you could switch to using the parabolic SAR as the stop level. Of course, during the day, there can be other signals that could prompt you to move your stop. If the price breaks through a new resistance level, that resistance then becomes support. You can place a stop 20 pips below that support level, even if it is only 30 to 40 pips away from the current price. The underlying principle you have to use is to find a point to place your stop where you would no longer want to be in the trade once the price reaches that level. Usually the stop falls at a point where the price goes below support.

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