Tuesday, May 02, 2006

Forex risk management

Basic, but important steps to control risk and limit losses.

"Cut your losses and let your profits run"

This is a cliche you will hear time and time again. But, how do we adhere to this maxim.

Our first defence, is limiting the size of the trade we are doing relative to our account level. We should not be risking more than 1-2% of our account capital per trade.

Second in our toolbox is using our stop loss (SL). Our SL sets a limit to our potential loss. That is, if a trade goes against us by a margin determined by us we would close the trade and take the loss. This is a totally automatic process in most trading platforms - providing you set it! I would suggest a SL of between 25 - 35 Pips. Again this depends on your risk tollerance. Losses in Forex trading are inevitable, and should be viewed dispassionately as part of the learning process. Never trade without a SL.

Thirdly we can also use a trailing stop loss (TSL)to lock in profits.
A TSL works like this. After entering a trade, instead of entering a take profit (MT4 Platform) - although you can still do this if you wish, I set a TSL of 15 – 25 Pips. After the trade has risen in profit by 15 Pips my TSL is activated. This means that my worst scenario from this point is break even, as my TSL will activate a close out once the trade retreats by 15 Pips. The beauty of it is, that as the price continues to rise – so does the TSL. If we eventually end up 30 pips in profit, and the trade subsequently drops to a negative, our TSL will cash us out at a profit of 15 Pips. TSL is usually used by currency and stock traders as a long term strategy, but I like to use them to lock in profits and in choppy markets where you can get bounced from profit to loss in an instant. It also follows our rule of letting our profits run, which hopefully they will!

Trailing stopp losses are also useful tools for watching a trade when you can't. If a profitable trade reverses on you while you sleep, a TSL can save your blushes - and still fill your pockets :-)
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