PART D – Risk Management

Introduction

Risk management is the most important part of trading. You have probably heard this hundreds of times from brokers, blogs and other books on trading. I would go one step further and say that your risk management strategy defines you as a trader. Without it, you are nothing more than a gambler.

In trading there are losses and if you want to succeed you must accept this fact. You will probably lose on more than half of your trades, but a good risk management plan means that you can still make money even if you lose more trades than you win.

In this chapter I will not go into great depth about the concept of leverage in the FX market or margin requirements. There is a wealth of information out there on these concepts. A simple internet search can give you concise explanations. I recommend Baby Pips (www.babypips.com), Investopedia (www.investopedia.com) and Currency Trading for Dummies by Brian Dolan as good resources for beginners.

Likewise, you won’t find any complex calculations for working out position sizes in this chapter. There is plenty written about this already and most brokers will provide you with position size calculators. Instead I will give you the risk management rules that I think make for the best trading. I will use case studies to show how risk management techniques fit into my trading approach.

Top five risk management tips

Here are my five steps for fail-safe risk management:

1. I use fundamental and technical analysis to determine which currencies to go long and short.
2. Once I have decided on which pair to trade I limit my maximum loss by giving the trade a cut-off point. This is also called a stop-loss and determines how much I am willing to lose on this trade if the market goes against me.
3. When I have decided how much I am willing to lose I then need to set a profit target – how much do I want to win from this trade? The combination of stop loss and profit target is known as a risk/reward strategy.
4. Trade size is the next thing to nail down. I need to ensure that all of my trades are appropriate for the size of my FX account. Professionals usually only risk 2% to 3% of their total capital on any one trade and this is a good rule to stick to when trading FX.
5. I try to manage my emotions and don’t stray from my risk management plan.

I will now show you how I put these tips into practice with a trading example.

Trading examples

Case Study 1: EURUSD

Background

It is July 2012 and EURUSD has started to look extremely oversold.

Action from the ECB looks like a credible attempt to reduce credit risk in the currency bloc’s peripheral nations. Since the euro is sensitive to changes in perceived credit risk in the peripheral member states, the ECB’s proactive efforts combined with oversold signals in EURUSD make me want to go long.

There is also a technical signal that makes me think maybe the downtrend is starting to fizzle out (see Figure 4.1). In the first week of July there is a bullish harami pattern – a small positive candle comes after a long down candle. This suggests that the market tried to push the euro lower, however the bullish sentiment was weak and could not be sustained. The bullish harami pattern is one of the first signs that a trend could be changing. When I see this pattern I start to think about going long, which is just what I did.

Figure 4.1: EURUSD

Risk management strategy

There are three stages to this:

1. Find a good entry and exit level, along with a stop loss to limit my losses
2. Decide how much I am willing to lose on this trade
3. Calculate the correct position size for my risk tolerance – basically ensuring that I don’t lose more than I have planned, or more than I could afford.

So the first thing to do is find my levels. I want to enter this trade in the first week of August when EURUSD is trading at 1.2225. I now need to find a good stop loss level. The bullish harami bottom that I identified in Figure 4.1 is at 1.2060, which would allow me to put a stop at that level 165 pips away (1.2225 - 1.2060 = 0.0165).

To ensure that I can lose more trades than I win and still retain a profit I need to ensure that my profit target is at least twice as large as my stop loss. In this example I would want to aim for a 330 pip profit at 1.2555 as my first profit target. Figure 4.2 shows the chart of EURUSD with my stop loss and take profit targets marked.

Figure 4.2: EURUSD with stop loss and take profit levels

Position size

So I know how much I want to risk and what my stop loss and take profit levels are. The next thing I need to do is decide how much of my trading capital I want to risk. After all, that is what trading is all about: deciding how much I would be willing to risk on this trade in an attempt to make a profit.

As I mention above, a good rule of thumb is to only risk 2% on any one trade. Hence, if I have a £10,000 account then I only want to risk £200 on this trade. To ensure I only risk this amount I need to place my stop loss at a level that is appropriate for my entry level.

I like to use a position-size calculator to figure out the optimal size of my trade. At this stage it is worth pointing out that FX is traded in lots; for example you buy or sell 1 lot of EURUSD. However, lots come in different sizes. A standard lot of EURUSD is the equivalent of trading $100,000, however you can also trade mini-lots that are the equivalent of $10,000. In this example I will trade mini-lots of EURUSD. These are more appropriate for my risk tolerance levels, as I only want to risk 2% of my capital base on each trade.

Now I am ready to calculate how many mini-lots I can buy to ensure that I don’t breach my risk limits. Here is a quick and easy guide.

Most brokers now offer position size calculators so I don’t really need to do this long-hand. However, it is worth understanding the workings behind the calculations.

The first thing is calculate how much I want to risk:

2% of my £10,000 capital base = £200

Since I am trading EURUSD contracts worth $10,000, each pip is worth $1. Remember, the pip value is quoted in dollars since USD is my counter-currency in this cross.

I am willing to risk 165 pips on this trade. Since my FX account is in pounds, it is more useful for me to find the per pip value in GBP. Let’s say for argument’s sake that the GBPUSD exchange rate is 1.6000, this means that each pip is worth GBP0.6.

Since I am risking 165 pips, 1 mini-lot of EURUSD would cost me GBP99 if the trade went against me:

165 x 0.6 (per pip value in GBP) = £99

That means I can trade two mini-lots of EURUSD and only risk GBP198, which is within my risk tolerance level of GBP200 (it is less than 2% of my £10,000 account).

A quick word on margin and leverage

It is worth bringing up margin and leverage at this stage. When you trade FX you trade on leverage. That means you only need to put up a relatively small amount of capital to get a much larger exposure to the market. For example, if I trade 2 mini-lots of EURUSD I am trading the equivalent of $20,000 while only risking £200 of the cash in my account. Some brokers offer leverage in excess of 100:1, which means on a £10,000 account you can have access to £1,000,000 worth of FX contracts.

However, for the privilege a margin requirement has to be put up in the form of a minimum balance in your account. Brokers shouldn’t allow you to have a negative balance in your account, and will liquidate your positions before you get into negative territory. So watch out, and always make sure you have enough margin in your account to stay in your positions.

Conclusion

In this example, I would buy 2 mini-lots of EURUSD with an entry level of 1.2225, a stop loss at 1.2060 and a take profit level at 1.2555 (using a 2:1 risk/reward ratio). The size and risk parameters of this trade ensure that I am only risking 2% of my capital (£200).

Case study 2: trailing stop loss

What to do during the trade

The middle of a trade is always a difficult time. I don’t want to forget about the trade but, equally, I don’t want to start fiddling with it because I’m bored. Here are a couple things I do with my time whilst in the middle of a trade:

1. Keep up to date with the economic data and the news-flow that is relevant to the trade. For example, if I am trading EURUSD I make sure I keep an eye out for the latest payroll data in the US, euro zone PMI reports, and ECB and Fed meetings. I ask myself whether the data or central bank meetings have changed the landscape for the currency and whether it will impact the trade?
2. I keep an eye on the charts. If you are a medium-term trader with a trade horizon of a few weeks then it is worth checking the charts at least once a day. If your time horizon is shorter then consider checking the charts more frequently.

What I do if the trade is going in my favour

Let’s say I bought 1 mini-lot of EURUSD and the trade is going in my direction – I stand to make a profit. What should I do now? This is tricky.

Why come out of the trade if I think that the trend is going to continue? However, I have a plan and I should stick to it, right? Well, yes, but all good plans need a little tweaking sometimes. That is where the trailing stop loss comes in.

Using the example in Case Study 1, I entered a long EURUSD trade at 1.2225, my stop loss is 165 pips away at 1.2060 and I have a 2:1 risk/reward ratio, which means that my profit target is 1.2555.

Let’s say the market moves up by 90 pips to 1.2315. The market is going in my favour, but I have now exposed myself to 255 pips of loss as my stop loss remains at 1.2060. If the market moves against me now, I could potentially get stopped out and lose the initial gains I had made.

To avoid this situation, after a sizable move in my favour I move my stop loss. Most brokers will allow you to move your orders around while you are in a trade; get your sales representative to talk you through it if you are uncertain of how to do it.

If I move the stop up to 1.2265 (giving myself a 50 pip stop on the price at which EURUSD is currently trading) then I would have made a guaranteed profit from the trade, since my stop loss is now 40 pips above my original entry point at 1.2225.

Although you can rest easier when you use a stop loss, the opportunity to trail stop losses and lock in profits is a good reason why you shouldn’t ignore your trade. I check on a trade at least once or twice a day (preferably three times if possible) to see if it is going in my favour. I actively manage my trades and move my stop loss if the risk/reward ratio starts to go out of whack.

Some brokers offer an automated trailing stop loss. You specify the amount of pips and the system moves your stop loss to ensure it is always that far away from the current price. This removes a time-consuming manual process and ensures that you don’t forget to adjust your stop loss and protect your profits.

What I do if the trade isn’t going in my favour

In Case Study 1 I added a stop loss level to my order ticket. So if the market goes against me then after a certain level has been reached I will be stopped out.

The stop loss meant that I was willing to risk £200. Losing is part of trading. The problem arises when the trend appears to change midway through the trade and I want to know what to do: stay in the trade until I get stopped out, or cut my losses now?

If there has been a large shift in the fundamentals underpinning the trade – say a natural or geopolitical disaster, a surprise shift in stance from the central bank or a raft of weak economic data – then I may decide it is better to cut my losses and get out before the stop loss level is reached.

But this does not happen often. In general I would not tinker with my trade. I made it for a reason and chose the stop loss and take-profit levels for a reason. If a trade goes against you it is not always because there has been a shift in the fundamental backdrop and the trend is changing, it may be because the market does not always go up, or down, in a straight line. Thus, I wouldn’t want to close the trade too early, especially if the market is experiencing a pullback before continuing its prior trend.

Case study 3: managing emotions

In my experience how well you manage your emotions depends on the person. There is no strict formula you can apply; some people are just better at it than others.

I have worked with some professional traders who were paid a lot of money by big corporations to trade FX and if a trade went against them they would roar or shout (generally at junior members of staff) or fall into a deep depression. Likewise if a trade went in their favour they would be beaming, almost doing a lap of honour round the trading floor like an Olympic gold medallist. Both are the reactions of people who cannot manage their emotions.

This does not mean that you need a poker face when you are trading, just that you should try to keep waves of feeling at bay. The markets are capricious beasts: they like you one moment and they hate you the next. And just like the Gods on Mount Olympus they will punish hubris.

The best traders I know spend their energy doing their homework – fundamental and technical research – to get the best possible stop loss, entry and take profit levels. The best lesson I ever learnt at journalism school was that the facts are your friend. This works in most areas of life, but especially in trading.

Some experts will tell you to write a diary. In my experience writing a diary does not automatically help you to manage your emotions in a trade, but it is simple to do and can be of use. Before you put the trade on ask yourself why you are doing it and write this down. This does not need to be a long treatise. Using the EURUSD example at the start of this section you could write:

“ECB President promises to stand behind the euro during the sovereign debt crisis, which has helped to reduce credit risk and should benefit the currency. There have also been some strong trend reversal patterns at 1.2060, which is now a psychologically important level, and suggests to me we have put in a low.”

Next jot down the dynamics of your trade:

“I am entering the trade at 1.2225, I want a 2:1 risk reward ratio and I am happy to run this trade over a number of days as I believe it could last a while. Hence, I will put my stop loss 165 pips away at the 1.2060 low and target a 330 pip profit at 1.2555.”

There is no need to give an hour-by-hour status update on the trade. Instead update only any changes you make like trailing stop losses, partial profit taking, etc.

Now let’s say that I eventually close out of the trade at 1.2700. However, when EURUSD breaks above 1.2810 and when it gets to 1.2950 I believe it could get as high as 1.3500. I jump in but within a few days the trend has reversed and EURUSD is falling and I am at risk of losing money. See Figure 4.3.

Figure 4.3: EURUSD (January to October 2012)

This is where a trading diary can act as a post mortem of the trade and help you to learn from your mistakes. There was no fundamental or technical reason for entering the second EURUSD trade – instead I went long because I made money on this trade before. This is a common mistake, but a deadly one. Remember: the facts are your friends. Doing well in the trade previously and having a feeling that it will continue to do well are not good enough reasons to enter a similar trade in the same market now.

Risk management wrap-up

1. I always make sure there are both fundamental and technical reasons to go into a trade.
2. I use stop losses before the trade and trailing stop losses once I am in a trade.
3. I monitor the charts during a trade.
4. I manage my emotions. If you are an emotional person then remember that the facts are your friend and facts are what you need to be a good trader.

Conclusion

So you have made it to the end of the book; either you read it cover to cover or you did what I do and start with the last few pages first! This book is not designed to make you the best trader in the world, rather it is designed to show you how I do things – to help you to look at the market from a different slant – and learn how to take the best bits from technical and fundamental analysis.

In an ever-evolving forex world, the day trader can feel pushed out by high-frequency trading and algorithms. However, doing the simple things right – such as using the fundamental indicators and chart pattern techniques that I show – can still result in trading success.

Rather than finish the book with another anecdote of my history working in financial markets, I thought I would try to leave you with something useful – my top ten tips for trading. They are not all original, some of them I have collected while reading various trading books and blogs, others I have been told or wish I had been told. I hope that you find them useful.

My top ten tips for trading

1. Learn, learn and learn. Whether you are a novice or a seasoned pro, never stop learning. It’s important to keep abreast of new technology that could alter the way you trade and hopefully make it easier. You also need to be aware of current trends and new economies that are growing in importance. Technical analysis is all about knowing what the street is thinking and to find that out you can read blogs, the financial press, look at charts, learn patterns and join trading communities. There are a lot of free resources out there and it is worth making use of them.
2. Practice. It can be easy to get bogged down in the theoretical detail, but once you have your strategy pinned down, put on a trade. At first it can be petrifying especially if you see your money slip away. However, you will learn how to deal with those emotions in time. Once you have a bit of practice behind you of forming a logical, well-reasoned trade idea, creating a set-up and implementing a strong risk management process, then getting a trade right can give you an immense feeling of satisfaction.
3. Start small. Don’t ever bet the ranch, but definitely not at the start. If you are new to trading you need time to adjust to how markets and your trading platform work. You may make mistakes so don’t let them erode too much of your capital base. Even a seasoned pro using a new trading strategy for the first time would go back to smaller position sizes until they get the hang of it. Start small and then build your sizes up as your capital base increases.
4. Always remember this process and etch it on to your brain: entry level, stop-loss, take-profit and risk/reward. This is a simple but vital risk management process that can save you a lot of headaches down the road.
5. Don’t compromise on your stop-loss or risk/reward ratio and don’t tinker with them in the middle of a trade (if using a trailing stop loss define your risk tolerance before you enter the trade).
6. If you lose, remember that it shouldn’t matter if you have a good risk management strategy.
7. If you don’t have time to put together a proper trade set-up and implement a well-researched risk management technique then don’t trade. Come back and trade when you do have the time.
8. Remember that fundamental analysis can give you a good idea for a trade and it can even help with timing your trade if you are using an economic data release, but you can’t rely on this alone. Technical analysis gives you entry and exit levels and stop loss levels, which are vital for your trade to perform well. This can make trading less stressful and hopefully more profitable.
9. Cut through the jargon. There are hundreds of technical and fundamental indicators that you could follow, but sometimes it’s hard to see the wood for the trees. Slow down, choose indicators that you like and that make sense to you. If you are using technical analysis, make sure that you can always see the price action on your chart. Some of the best traders choose a couple of moving averages and a MACD and have great success. The key is to choose what you are comfortable with and stick with it.
10. Don’t let trading take over your life. You can do it every day and love it, but trading is a very solitary activity, and you live and die by your decisions. Take time out. Life is short so enjoy spending time with friends and family away from the markets. I always find this clears my head and I get back to my desk brimming full of ideas.

I hope that you have found some of these tips useful and that they can serve you as well as they have served me.

Thank you for reading and good luck trading.

Kathleen

Appendix

Suggested reading list

These are some of the resources that I look at daily. I find them useful and you may too:

• Financial Times (www.ft.com)
• Wall Street Journal (www.wsj.com)
• The Economist (www.economist.com)
• FT Alphaville (ftalphaville.ft.com)
• The Big Picture (www.thebigpictureblog.com)
• Zero Hedge (www.zerohedge.com/blog)
• Baby Pips (www.babypips.com)
• Stock Twits (stocktwits.com)

Bibliography

Throughout my career I have read a huge amount of literature on forex (partly to make up for the lack of economics or finance degree) but these works have been particularly helpful to me during the writing of this book:

Peter L. Bernstein, Against the Gods: The Remarkable Story of Risk (John Wiley & Sons, 1998)

Jesse Livermore, How to Trade in Stocks: The Classic Formula for Understanding Timing, Money Management and Emotional Control (McGraw Hill, 2001)

John J. Murphy, Intermarket Technical Analysis: Trading Strategies for the Global Stock, Bond, Commodity and Currency Markets (John Wiley & Sons, 1991)

Barbara Rockefeller, Technical Analysis for Dummies (John Wiley & Sons, 2004)

Peter Temple, CFDs Made Simple: A Straightforward Guide to Contracts for Difference (Harriman House, 2009)