in and out ofposition within a given trading day using extremely short chartingtimeframes and well-defined technical signals.Besides these general approaches to trading foreign exchange,there are other delineations of trading methodology. On the technical trading side, these include trend trading, range trading, breakouttrading, and pattern trading. Trend trading, or trend following, utilizesprimarily technical analysis to identify the overall trend, and then todetermine the best place to enter that trend. In the absence of a trend,traders will often go into range trading mode, where lows are boughtand highs are sold during sideways trading ranges. When a range orsupport/resistance level is broken to the upside or to the downside,breakout trading takes precedence. Traders will then buy on a breakabove or sell on a break below. One type of breakout trading occurswhen chart patterns are broken. Common examples of traded patternsinclude head-and-shoulders, triangles, wedges, flags, and pennants.
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Chapter Summary
Yet other common methods for trading forex include strategiesthat utilize the powerful analytical tools of Fibonacci, pivot points,and Elliott Wave. Each of these tools commands its own loyal following among traders, and each has its own unique approach toforecasting price movement.Divergence trading seeks to identify instances when price andan oscillator are diverging in direction. This often means a potentialloss of momentum in the prevailing price direction and therefore apossible impending reversal. Divergence signals are often reliable inhelping to forecast or confirm these potential market turns.Multiple timeframe trading is an excellent all-encompassing methodology for entering into high-probability currency trades. Startingon the longest timeframes to identify trend, multiple timeframe traders then drill down to progressively shorter timeframes in order todetermine, and ultimately pinpoint, the most advantageous trade entrypoints.Point & figure trading utilizes an entirely different type of chartfrom the commonly used bar or candlestick charts. Point & figurecharts are filled with Xs and Os, and they excel at identifying trends,support/resistance, and breakouts, while minimizing the representation of market noise.On the fundamental analysis side, carry trading, news trading, andcontrarian trading are some of the primary strategies and methods.Carry trading works on the interest rate differential inherent in currency pairs, and seeks to earn a positive yield on both this differentialand directional exchange rate movement. News trading exploits pricespikes and other types of fast price action that occur around economicdata releases and fundamental news announcements. Contrarian
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trading takes the position that the general consensus as expressed bythe media, the analysts, and the trading public, is inherently wrong,and that it is best to trade against this consensus at market extremes.Finally, backtesting and autotrading are two important components of implementing trading strategies that generally do not relyupon the trader’s judgments or discretion. These types of strategiesare primarily technical in nature, and they must necessarily haverules and criteria that are unambiguous. Backtesting allows the traderto determine if a given strategy would have been profitable usingpast price data, which is an indication of how it might potentiallyperform in the future. In contrast, autotrading actually executes realtrades automatically according to a pre-programmed set of instructions that sets trade entries, stop losses, and profit limits.
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CHAPTER 6
Important Elementsof Successful ForeignExchange TradingAfter reading this chapter, you will beable to:●
Understand some of the most important elements ofsuccessful trading that many novice traders are reluctantto learn.
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Recognize the crucial difference that good risk management and money management can make in forex trading.
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Realize that most experienced and successful tradershold the preservation of capital as their top priority,thereby helping to ensure that they are at least aroundto trade another day.
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Apply proper and consistent trading discipline to strivefor the best chances of success in forex trading
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Appreciate the necessary elements that go into a comprehensive trading plan.
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T he Boring Side of SuccessAfter all of the excitement learning about trading strategies thatseem to hold great promise of future profits, most novice traders arereluctant to come back down to earth and learn about the “boring”side of successful trading. This includes risk management and moneymanagement, discipline and psychology, and a proper trading plan.Some novice traders may deem these subjects unnecessary, aslong as their “sure-thing” trading strategy produces profits. But thisline of thinking could not be further from the truth. In order tomaintain any hope of becoming consistently successful, traders mustlearn and internalize certain good habits that have nothing to dowith market analysis or the mechanics of putting in trades. Rather,these crucial elements of intelligent trading constitute a way of lifethat virtually all of the most successful traders have adopted to onedegree or another. Let us begin with a discussion of risk.
A Risky BusinessPerhaps more than any other type of financial trading, foreignexchange trading makes it extremely difficult for inexperiencedtraders to manage risk effectively. This is partly due to the fact thatthe leverage offered in forex is so high when compared with othermarkets. When $1 in margin can control $100 or more in a trade,the potential for profit is magnified to an extreme degree. But manybeginners seem to forget that the risk of ruin is magnified just asmuch. High leverage can certainly be a powerful feature in a positiveway, but it can also have a way of tempting unsuspecting traders intobecoming reckless and greedy. As we will soon find out, recklessness
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F a t t e r I s H e a l t h i e r ( B u t O n l y f o r Tr a d i n g A c c o u n t s )
and greed are two characteristics that, at some point, will invariablydestroy a trading account.This brings us to the number one priority of successful traders—preservation of capital. Risk and money must be managed in a waythat the ultimate goal is to survive to trade another day. Withoutthis, all is lost and the game is over. Many experienced traders go astep further by subscribing to the winning philosophy that if virtually every ounce of focus is concentrated on preserving capital, theprofits will take care of themselves.
F atter Is Healthier (But Only forTrading Accounts)There are many important ways in which traders can work towardthe goal of preserving capital. The most obvious initial step is tohave enough capital to begin with. But how much is “enough?”First, it depends on the amount of risk capital one can afford toput aside for trading without substantially impacting one’s lifestyle. Then, it depends on the size of the positions that one will betrading. But just because there is sufficient margin on account toopen a certain position, does not mean that a trader has sufficientcapital to trade successfully. For example, many beginners believethat if $1000 is required as margin for one standard lot trade of$100,000 at 100:1 leverage, $1000 is enough capital to have in theaccount for making the trade. This could not be further fromthe truth. Having only enough funds in an account to cover theminimum required margin for a given position is one of the quickest routes to disaster.
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The exact amount of money that is considered “enough” andsufficiently capitalized will vary from trader to trader. But one general guideline used by many prudent retail traders is always to havein the account, at the very least, ten times the amount of marginrequired for a typical trade. So, for example, if a trader wishes to tradeone mini-lot of $10,000 at a time at 100:1 leverage, where the margin required is $100, that trader should always have at least $1000in the account. By the same token, if a trader wishes to trade onestandard lot of $100,000 at a time at 100:1 leverage, where the margin required is $1000, that trader should always have $10,000 in theaccount at the very least. This, again, is only a very general guideline,as each trader’s risk profile and risk appetite will necessarily differ.
R isk and RewardAfter overcoming the first hurdle of being properly capitalized, thetrader can then turn attention to creating a risk/money managementplan to preserve capital. One of the key components of this plan isto set consistent risk parameters with regard to stop losses and profittargets. These should be set in accordance with a properly plannedrisk:reward, or perhaps more aptly named, “reward-to-risk” ratio.The reward-to-risk ratio is a simple concept that can workwonders for the overall profitability of an account. While optimalreward-to-risk ratios can be difficult to attain in everyday trading,foreign exchange traders should always strive for the best, or highest, ratios possible. A rather high ratio like 4:1, for example, simplymeans that on any given trade, a trader is looking to profit by fourtimes the amount that the trader is prepared to lose. In real-world
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terms, this means that if a trade is entered with a 30 pip stop loss, forexample, the profit target would be set at least at 120 pips. The ramifications of the reward-to-risk ratio are considerable. With a goodratio, traders can actually lose significantly more trades than theywin, and still be consistently profitable. This is because their averageprofits are much larger than their average losses. The concept of ahigh reward-to-risk ratio lends itself well to the oft-repeated trader’smaxim, “Let your profits run and cut your losses short.”So what exactly is the optimal ratio? It can be difficult in tradingforeign exchange to achieve ratios as high as 4:1, because at a certainpoint with these higher ratios, the trade-off is that losses becomemuch more frequent than wins. Since the wins would be muchlarger in dollar value than the losses, this is perfectly fine from along-term profitability standpoint, as mentioned earlier. But the psychological toll of excessively frequent losses, even if relatively smallin value, can eventually become devastating to a trader’s psyche.Generally speaking, many forex traders like to target a reward-torisk ratio of 3:1 as the ideal. This means that each profit is targetedto be at least three times as large as each loss.While 3:1 may be optimal, however, shooting for 2:1 can often bemore practical in many real-life trading situations. The trick in consistently achieving good ratios like these lies in adapting the ratios toprevailing market conditions. For example, if a certain chart pattern isidentified on a currency pair, the technical trader will need to makesure that a profit target two or three times the magnitude of the stoploss is realistic before taking the trade. This is just prudent trading. Butif the trader rigidly adheres to unrealistically high ratio requirements,this may result in too many voluntarily missed opportunities. The
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best solution is often the middle path—a reward-to-risk ratio that ishigh enough to achieve long-term profitability, while low enoughto fit market conditions realistically. Therefore, the true optimal ratioultimately depends on each trader’s own experimentation and whatworks best through actual experience.
F ix Your FractionsBesides finding the right reward-to-risk balance, another importantaspect of a money management plan that focuses on capital preservation is called fixed fractional money management. This generallyrefers to the percentage of total account equity that a trader is willing to risk on each trade. So, for example, if a trading account has$1000 in it, and the trader trades one mini-lot (10,000 units) at atime for approximately $1 per pip, a fixed fractional plan of 3% oftotal equity would necessitate a 30-pip maximum stop loss on eachmini-lot trade. Why? Because if the trader wants the maximum riskper trade to be set at 3% of $1000, or $30, and each pip is worthabout $1, that would mean the trader could accept losing up to 30pips on each trade. This would necessitate putting in stop losses thatare a maximum of 30 pips away from the trade entry for all trades.Contrary to the common belief that fixed fractional money management refers directly to the percentage of account equity actually putup to make a trade, the real meaning generally refers to the percentageof total funds placed at risk on each trade as it relates to stop loss placement (along with position sizing). Therefore, the fact that $100 of atrading account’s total $1000 is put up in margin for a trade does notnecessarily mean that 10% of account equity is being risked on this
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trade. Only if a stop loss of 100 pips (at a value of $1 per pip) is instituted into this trade would 10% of total equity actually be risked.Many traders do not favor fixed fractional money management because it encourages the basing of stop losses on an arbitrarynumber that generally has very little to do with prevailing marketand trading conditions. For example, a 30-pip stop loss may be perfectly reasonable for a trendline breakout trade on an hourly chart,but may be completely inappropriate for a head-and-shoulders tradeon a weekly chart. Just because the fixed fractional percentage maywork well for a trader’s money management profile, does not makeit appropriate for every type of trade entered.At the same time, however, fixed fractional money management,when used more as a restraining guideline than as a strict stop loss value,can serve as a very effective deterrent against the self-destruction of atrading account. So instead of specifying an exact (fixed) percentage riskfor each trade, it often works better for traders to loosen the percentageand make it a maximum risk parameter. For instance, instead of creating the rigid rule that exactly 2% of total equity will be risked on eachtrade, a more adaptable rule might be to require that no single trade canhave a stop loss that exceeds, for example, 4% of total equity. As long asthe stop loss represents less than the predetermined maximum percentage of account equity, it can be fine-tuned, with the additional help ofposition-sizing, to suit the prevailing market and trading conditions.
T railing Stops — Loyal FollowersIn general, stop losses are an integral component of good risk management. To go a step further in the right direction, the liberal use
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of a trailing stop loss strategy can do even more for a trader’s bottomline. A trailing stop, as explained in Chapter 2, is a dynamic order toclose a trade at progressively better prices.So, for example, a trader buys EUR/USD and applies a 30-piptrailing stop to the trade. If price moves in the profitable direction for this trade (i.e., up), the stop loss follows price by 30 pips.If price moves at least 30 pips above the entry point of the trade,profits begin to be effectively locked in. This process is automaticallyaccomplished by the trailing stop mechanism. If, at anytime, pricemoves down by 30 pips, the trade gets closed out by the movingstop loss. Theoretically, if there is no profit target set and price keepsmoving up forever without fluctuating down by at least 30 pips, thetrade could gain unlimited profit. Of course, this would never happen in the real world of trading, but it just displays the potentialpower of the trailing stop.From a risk management perspective, trailing stops can automatethe twin concepts of cutting losses and letting profits run. A trailingstop ensures that a protective stop loss is always in place, and provides an easy way to secure hard-earned profits on an ongoing basis.Trailing stops can be instituted automatically using a trading platform’s trailing stop function, or can be performed manually simplyby moving the static stop loss on an open position in logical increments as price moves in the trade’s favor.
S ize MattersVery closely related to sufficient capitalization, reward-to-risk ratios,and fixed fractional money management through stop-loss placement,
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Size Matters
is the sizing of trade positions. Position-sizing is a vital aspect of goodmoney management. In fact, sufficient capital and sensible positionsizing go hand in hand to help curtail risk and prevent the depletionof a trading account.As discussed earlier in this book, there are three primary position sizes in retail foreign exchange trading. Trading accounts withthe smallest equity usually trade the micro, or super-mini, lot. Theseconsist of 1000 units of a given currency, and the dollar valueper pip is approximately $0.10. The next size up, traded by slightlylarger trading accounts, is called the mini-lot. Mini-lots consistof 10,000 units of a given currency, and the dollar value per pipis approximately $1.00. Finally, for even larger accounts there is thestandard lot, which consists of 100,000 units of a given currencyand whose per-pip dollar value is approximately $10.00. Tradingaccounts that are even larger than this may trade in multiple standardlots at a time.Which size is best? It all depends on how well capitalized theaccount is, as well as the particular risk profile of the trader. As notedearlier in this chapter within the section on being properly capitalized, there are some rough guidelines that many prudent tradersfollow when planning their trade size and account capitalization.For example, a trader planning on trading standard lots of $100,000,where the margin required per trade is $1000 (at 100:1 leverage),would probably want to have $10,000 in trading account equity, atthe very least. At the same time, however, this does not necessarilymean that a trader with $10,000 in a trading account has to trade instandard lots. Mini-lots are perfectly fine, even for larger accounts,and they actually have an advantage over standard lots. Mini-lots
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are much more flexible than standard lots in providing the abilityto trade in odd unit sizes (e.g., 70,000 currency units traded with 7mini-lots, as opposed to a 100,000 unit minimum for standard lots).In addition, mini-lots can accommodate multiple fractional positions(as explained later in this section).Clearly, one of the most significant results of trading larger lotsizes is the increased dollar value per pip. Among other effects ofhigher pip value is that it can obviously impact trading psychology agreat deal. Any trader knows the difference between having a smallamount on the line and having a great deal on the line. A traderwatching $1/pip price movements is generally less apt to sweat andmake rash trading decisions than the one watching $10/pip pricemovements.Overtrading with regard to position-sizing often forces thetrader either to abandon proper money management principles orset stop losses that are unrealistically close. This is due to the factthat in order to retain the same risk profile, higher pip values necessarily mean a smaller number of pips to cushion the trade. The primary point about proper position-sizing is to avoid overextendingaccount capital and getting into financially uncomfortable tradingsituations.Closely related to overall position-sizing in the realm of riskmanagement is the concept of multiple fractional positions. This isyet another method to help spread and control risk. Multiple fractional positions are smaller components of the main trade. Thesesmaller positions may be entered all at the same time, and then eachfractional position can progressively be closed in a staggered manner
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to lock in profits as the position moves in a profitable direction. So,for example, if a trader enters into a long position using 10 mini-lots(instead of 1 standard lot), each mini-lot can be closed for a profit asthe price increases, thereby securing partial profits in a progressivefashion.Another method of spreading risk using multiple fractionalpositions employs staggered entries, as opposed to staggered exits.Each fractional position would be entered at a different price level.Because it is extremely difficult to pinpoint precisely the best singleentry on a trade, multiple fractional entries allow traders to get in ona position within a flexible price range instead of at just one price,thereby spreading some risk among different price levels.
P osition OverloadAlso closely related to overall position-sizing is the common affliction of overtrading by opening too many full-sized positions (asopposed to fractional) at the same time. In foreign exchange trading,the danger in overtrading lies in more than just the overextension ofaccount margin, although that is also of grave concern.The danger that is often overlooked in this market stems fromthe fact that, relatively speaking, there are so few different instruments that are practically tradable. This means that it is extremelydifficult, if not virtually impossible, to diversify holdings adequately.In addition, the primary trading instruments in foreign exchangetrading are correlated very closely with one another. This can beeither a positive correlation or a negative correlation.
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In the world of equities trading, finding diverse, noncorrelatedinvestments can be relatively straightforward. In forex, on the other hand,the four most actively traded currency pairs, EUR/USD, USD/JPY,GBP/USD, and USD/CHF, are all dependent on the relative value ofthe U.S. dollar. The same is true for the next most actively traded pairs,AUD/USD and USD/CAD. Beyond this, there are only a handful ofcommon cross currency pairs that are not dollar-based, like EUR/GBP,EUR/JPY, GBP/JPY, and so on, but these are also extremely interrelated. Rounding out the list, most of the exotic pairs are not even practically tradable because of their intolerably wide spreads stemming fromtheir low liquidity. So if a trader/investor is involved solely in the forexmarket, diversification is simply not a viable option.Therefore, overtrading in forex can be doubly dangerous. Notonly does it create risk in overextending margin, but it also increasesexposure to highly correlated instruments.There are several ways to help mitigate this type of risk. Themost obvious way is to place a strict maximum on the number ofpositions entered at one time. This means that the trader must simply have the discipline to refrain from overtrading. Another way isto reduce the size of each individual trade, as in multiple fractionalpositions. This is an easier method, as it allows the trader to enterthe same number of positions as usual, while committing a muchsmaller amount to each position.Yet another method for combating correlation risk that manynovice traders try in the beginning of their forex explorations centers around attempting to structure a hedged currency portfolio forcontrolling risk. For example, since EUR/USD and USD/CHFgenerally have a relatively high negative correlation, going long in
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both or going short in both could potentially be considered akin toa hedged position with significantly reduced risk.In actuality, however, there is really no reason to trade like this,even if it does succeed in controlling volatility risk to a substantialdegree. Because currencies are traded in pairs, going long in correlated pairs like EUR/USD and USD/CHF, for example, simply creates a synthetic pairing that is akin to just going long a third pair,in this case EUR/CHF. In the same way, being short both EUR/USD and USD/CHF is like being short just EUR/CHF. The riskreduction in quasi-hedging of this nature is limited to reducingexposure to volatility by trading the much tamer EUR/CHF pair asopposed to the much more volatile EUR/USD or USD/CHF pair.Therefore, the entire exercise of opening two opposing positionsdoes not make a great deal of sense, as the same goal can be accomplished by the much simpler act of trading just the one synthetic pair.Other traders utilize their broker’s hedging functionality, whichgives the ability to be long and short in the same currency pair atthe same time, in the hopes that it will provide a reduced risk environment for trading. The issue with this perspective, however, isthat without any risk exposure to the market, neither profits norlosses can be made. So it is akin to not having any position at all.Therefore, hedging within the forex market, though it may be acomponent of certain specialized trading strategies, is not one of themore viable methods for controlling risk in general forex trading.In short, there are really no shortcuts to proper risk and moneymanagement. The best ways to combat the tendency to overtradeis simply either to cut back on the number of positions opened orreduce the size of each position.
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M easuring Risk with a TrendlineAs touched upon earlier in the book, the primary analytical methodfor measuring and controlling risk from a trading strategy perspective lies in the use of technical analysis. One of the greatest strengthsof technical analysis is that it allows traders to quantify precisely, andthereby help control, the risk factors inherent in trading.The most obvious risk control application of technical analysis isstop-loss placement. Technical analysis employs a simple and elegantrationale for determining the location of stop losses. When the technical reasons for getting into a trading position no longer exist orare no longer valid, that position should be abandoned, even if at aloss. The purpose of a stop loss, after all, is to cut losses while thoselosses are still manageable.For example, in a potential breakout situation where a trade isentered on a breakout above a certain price level, if price subsequentlyfalls back below that level, the reasons for entering the trade are nolonger valid. Therefore, the stop loss should be placed right underneath the breakout level, where the break will have proven itself to beeither false or premature. A failed breakout, as described above, is certainly a good reason to get out of a trade with a manageable loss.Here is another example of risk management from a technicalanalysis perspective. For a trader who has entered a short positionon a pullback up to a downtrend resistance line, if on one of thesubsequent pullbacks price exceeds that downtrend line by a significant amount, a good location for a stop loss would be right abovethe trendline. A break above the descending trendline would meanthat price is no longer pulling back and continuing the downtrend,but might perhaps be reversing its trend. If this is the case, a properly208
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Great Expectations
EXHIBIT 6.1
Technical Stop-Loss Placement
Source: FX Solutions – FX AccuCharts
placed stop loss above the line can potentially prevent a great deal ofpain. See Exhibit 6.1.Technical analysis, therefore, can be an essential component ofan effective risk management plan.
G reat ExpectationsAnother way in which risk management is related to trading strategy lies in the concept of positive expectancy. Even with all of thebest money management practices and risk control methods inthe world, a trader should not hope to achieve consistent profitability without a trading strategy that delivers a positive expectancy.209
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What exactly is positive expectancy? It simply means that thetrading strategy should consistently produce a net gain in equity.This could mean either a higher average number of winning tradesthan losses, or a greater average profit per winning trade than lossper losing trade (reward-to-risk), or any combination of the two.Positive expectancy is absolutely crucial to every trader’s questfor consistent profitability. It is related closely to risk managementbecause the higher the tested expectancy for any given strategy, thebetter the risk profile of any trader trading that strategy, all otherfactors being equal.In order to test and potentially improve a strategy’s expectancy,the most common method is to backtest the strategy. As discussed inChapter 5, backtesting can take one of two forms—manual and automated. Manual backtesting consists of looking back on historical chartsand manually applying trades according to the tested strategy. Thesehypothetical trades should then be observed and recorded to obtaina long-term record of performance. Automated backtesting, on theother hand, employs sophisticated software to apply and record tradesautomatically on historical price data. Results are quickly delivered tothe backtester, and the trader can then try to tweak the parametersof the strategy in order to fine-tune a strategy with a higher expectancy. At least some form of backtesting is extremely helpful, and almosta necessity, for creating a money management plan that works.
P sychologically SpeakingWhile this entire chapter thus far has been focused on risk and moneymanagement, which are extremely vital to a successful trader’s skill set,
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Psychologically Speaking
another important aspect of success in forex is trading psychology.Foremost within this realm of trading psychology is the concept ofdiscipline. Greed and fear are the two most dangerous emotions to atrader. Discipline is the remedy for these destructive emotions.The concept of discipline can take many forms. This includes