Monday, 6 March 2017

Lesson 3 – Introduction to Forex Trading - Understanding the basics - Part 3

Risk Management

buy sell dice

This is probably the single most important concept in trading and therefore any trading plan.
Risk management is the concept of protecting capital to ensure you can trade again the next day. It is also the key to creating a profitable strategy and becoming a consistently profitable trader - consistency being the key word.

Often, people describe money management in terms of utilising a set percentage of an account, or even ensuring that the profit target is larger than a stop-loss. In fact, the key to money management and risk management is actually understanding your strategy and trading style well.

Assuming you can consistently apply a given strategy, and know its average win ratio; and as long as you are then able to apply stop losses and profit targets in the same way for each trade, you can be certain of a being a profitable trader.

Some examples:
- If a strategy wins 90% of the time on average, then the trader can utilise a risk to reward ratio of anything greater than 9:1 to be profitable (i.e. 10 pip profit target on a 90 pip stop-loss).

- If a strategy wins 25% of the time, then the trader needs to utilise a risk to reward ratio of at least 1:3 in order to be profitable (75 pip profit target for a 25 pip stop-loss).

The challenge here is understanding how accurate or profitable a strategy is.

The easiest method for this is back testing, using computer simulators to work the statistical properties of a trading strategy. But in reality, know-how and good data and good software are required to do this accurately. Therefore, most traders will need to keep a track of their own trading in order to build a longer term view of how well their trading strategy/plan is working out.

The Importance of a Trading Log (again) 

The importance of a trading journal has already been mentioned, but this is one of the reasons that a record of your trades is so important. A log of not just your motivation for the trade, but also the set-up used, stop loss and profit target will enable you to learn from your own experiences and optimise your money management for your own trading plan and style of trading.

At the end of each week and month you should review your trading log; looking to see how close you stayed to your trading plan, whether your stop losses and profit targets were in the right place. Then, using this information and the charts of the trades you took, you should be able to amend your trading plan and money management techniques to ensure that in future positions you’re able to better maximise the trades and therefore your potential.

Utilising a small trading account, you can build up your experience, work out which trading strategy fits your personality best and work out a good money management system for your trading plan.

Stick to Your Guns

Finally, once you understand your risk to reward ratio, you need to stick to your guns. Don’t move stop losses and profit targets around unless this is a pre-defined part of your strategy (i.e. trailing stops).

All good traders stick to their trading plan and let the market come to them, not the other way round. This is very difficult to learn, but the majority of reasons why traders fail is that they move stops out and profit targets in. This means that instead of sticking to their money management plan, they take profit too early and stop out trades too late.

In Summary

Understand your strategy in detail; don’t get bogged down by the various people telling you that you need 2:1 or x% of your account on each trade, do your homework by keeping a log of all of your trades.

Convert percentage profitability to a risk-reward ratio:
(1 - %win rate)
%win rate

This will give you the multiple of your profit target to stop-loss size.

Once you have set your stop-loss and profit target, don’t chase the market; never move stops out.
Remember, you don’t have to win 90% of trades to be a great trader, but you do need to be consistent.

Risk vs. Reward in Action

As an example, consider a trader who always looks for at least 2 times what he risks (a key point on the trading plan).

Therefore, if his stop loss is 80 pips, he is looking for at least 160 pips profit on a trade. If his stop loss is 10 pips, he will be looking for at least 20 pips.

This is because he knows that on average he is right about 40% of the time.

Therefore, in mathematical terms his average profit is;
(40% x 160pips) – (60% x 80pips) = (64pips – 48pips) = 16 pips

This simple rule is key to trading: if you have a negative position on average, you are going to lose money overall.

Look over your trades, work out your average stop size and profit target and the % of times you hit your stop vs hitting your profit target (or closed the position).

Then do the simple maths above. Quite simply, are you profitable?

Remember when doing this that you need to ensure your lot sizes were the same, otherwise it becomes skewed.

For example, if the trader was trading a micro account (1,000 per lot) and took 2 lots per trade and closed one at 80 pips and one at 160 pips, the equation would be slightly different:

(40% x (160 + 80 / 2)) – (60% x 80) = 48 – 48 = 0

That slight change in money management has resulted in him being flat on average.

Stop Losses / Profit Targets

One of the great tricks to trading is letting winners run.

The best way to do this is to take 2/3rds of the trade off at the 2-reward level per risk (i.e. twice your stop loss), then trail the other 1/3rd.

For instance, let’s say you are trading the micro account again.

  • Enter your trade for 3 micro lots (3,000).
  • Place your stop at 80 pips for all 3 micro lots and place your profit target at 160 pips for 2 of your micro lots.

If you hit your profit target, you have closed out 2/3rds of your position for 160 pips.

  • Then move the stop loss up to 80 pips profit and leave the trade alone.
  • Every time it increases, move the stop loss up another 80 pips.

Now the maths:

Initially, calculate the average if your position retraces from my profit target and you had moved your stop to 80pips:

(40% x ((160 + 160 + 80) / 3)) – (60% x 80) = 53.34 – 48 = 5.34

Then think about what could happen if you trail your stops higher.

If the trade actually runs up and you get stopped out on the final 1/3rd at 160 pips above your initial target of 160 pips, that’s 320 pips:

(40% x ((160 + 160 + 320) / 3)) – (60% x 80) = 85.34 – 48 = 37.34

You are starting to see how you can quickly increase your average with a few good trades that continue in your initial trade direction.

The final trick to employ, which many people find hard to do, is adding to your position. Say you are in a trade, and that you need to see three moving averages cross in order to go long.

Take your initial long position with 3 micro lots, 80 pip stop, 2/3rds of your trade with a limit order to take profit at the 160 pips and 1/3rd being trailed at the 80 pips mark.
If you hit your target at 160 pips, there is a small retracement and you will get another entry signal when the three moving averages cross again.

It may seem obvious, but what you need to do is take the trade again, as if you didn’t have a trade in place already. In other words, go long again 3 micro lots and place your stop at 80 pips (still trailing the other stop), place your 2 micro lot limit order profit target at 160 pips, and look to trail the final micro lot.

This way, if there is a continued trend, you continue to build a bigger position at a better price (due to averaging of prices), so that when it finally reverses, all of the 1/3rds trailing stops that are in the money, and that get stopped out, will be of a considerable size.

Applying these three rules can turn anyone from a losing trader into a great trader. The key is to stop trying to be right, and start trying to be profitable.

The Importance of Managing Expectations

Be Patient. Not Greedy.

A lot of traders seem to aim for silly win rates, with many aiming to win 90% of the time. But there aren’t many wealthy or successful traders with a really high win rate.

The greatest traders have fantastic patience and money management rules and do not go for 90% win ratios. The main reason being that these ratios put a lot of pressure on the individual, and getting 90% win rates most likely involves taking an incredible amount of risk on losing streaks.

In order to survive in this game, you need to manage your money and focus on maximising your return per risk rather than finding a get-rich-quick scheme.

Find a Profitable Strategy

The second point a lot of traders struggle with is finding a profitable strategy.

There are typically two main issues here. The first is the trader that has bought lots of courses and systems, but is still failing. The truth is, some of those courses and systems will be curve fitted for a very specific environment, one in which it worked well initially, but now no longer performs. But, secondly, there will also be a fair few of these courses that will work, meaning that the challenge is with the trader.

More often than not, the best systems evolve around market principles, that is the underlying order book, support/resistance, supply/demand, and price action.

There are far more incredibly successful traders who use these concepts than any others. The real reason for this is that all these concepts are derived from the underlying order book that the market is made up from. Remember that the market is a series of opinions of what a fair price is, and these opinions get turned into orders within the market.

But the issue with most individuals is their ability to pull the trigger and stick to the rules. The key here is that traders are driven by fear. The old fight or flight instinct built into all of us is no different in trading, and this impacts most traders in some way. The crucial issue is how to deal with it, and this is why trading plans are so useful.

Translating fight or flight into a key trading concept is easy. Most traders fail because they hold onto losing trades for far too long and book profit far too early.

Fortunately, there are a number of handy rules to stick to in order to avoid falling down this common trap:

  • Set and forget – once a trade is set, along with a stop loss and profit targets based on sound money management rules, walk away and don’t come back to the screen for a specific amount of time. Go and watch a movie, get a coffee, take the dog out.
  • Remove all notion of money from trading platforms, only look at relative performance and pips whilst trading. If you have good money management and a profitable system you will be profitable in the long run. Therefore, ignore the size of the account you are trading with. This puts everyone on a level playing field, whether trading several million or 50k. 
  • Have a trading journal. Having to objectively write down why you are taking a trade along with the risk/reward and trading components make you really think objectively about the trade. 

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