Forex Trading can be very exciting allowing you to benefit from market volatility in ways that stocks do not. However, making successful trades can be very difficult and time consuming. At DailyFX we like to say that we are traders first and analysts second and we argue in this report that forex traders can maximize their chances of survival by following some simple rules.
“You must decide how much risk you’re willing to accept before you take a trade and you should not risk more than you can afford to lose. Indeed, investment in the currency exchange is highly speculative and should only be done with risk capital. In fact, it is probably best to be focused on the long-term as opposed to the short. For instance, on average during bear markets stocks fall 30 percent, and then they climb 47 percent within a year. In sum, it is important to buy warmer clothes in the summer to be able to survive to the cold of the winter.”
Have a Trading Plan “I always try to follow the general rules that I have laid out for myself but during turbulent market conditions I have to follow these rules. 1) Do not trade too large. I will not give specific numbers regarding leverage because everyone will have vastly different risk tolerances but if you get anxiety when you are in a trade, then you are in 'too big'. 2) Never completely reverse a position. In other words, do not cover shorts and immediately go long and vice versa. Decide whether you are a bull or bear and trade from that side only. 3) Minimize risk as much as possible. This means being more dynamic such as moving stops to breakeven when appropriate. Try trailing stops. Also, set a loss limit for the day; a certain percentage of your account. Again, I will not suggest numbers because everyone is different. “
Choose Your Time Frame Wisely
“While it never seems like it during the height of a panic, market conditions always revert back to some sort of normalcy. Indeed, looking back to past market crashes (like Black Monday in 1987 and the Great Depression), volatility eventually settled and the markets returned to speculation-as-normal soon thereafter. Knowing this, it is important to determine your trade time frame when taking new positions in markets like these as stops and targets are a natural extension for this strategy element. For traders that usually take a position that lasts a day to a week, market conditions like we are seeing now can spell disaster to an account as frequent explosions in volatility can blow through stops. Therefore, it is important to either decrease your time frame to be in and out before an unforeseen burst in volatility decides the trade or increase your time frame to rise above the ‘noise.’ For trades with wide stops and targets based on long-term fundamentals and technicals, even an extended period of abnormal volatility can be weathered.” Avoid Those Pairs That Are Highly Sensitive To Risk “This may seem like a no-brainer; but you may be inadvertently trading a risky pair without even knowing it if you don’t identify which risk-based trends are driving volatility. In today’s chaotic markets, all roads lead back to liquidity. Whether we are talking about bond and equity investors afraid of bankruptcies or speculators shying away from unexpected volatility, it all has its roots in the ability to easily and quickly transfer capital into more liquid and relatively risk-free positions. For the currency market, this means those pairs that have a low volume currency or a wide yield differential will be looking at dramatic price action – usually without direction. “
“While the saying ‘cut your losers short and let your winners run’ holds true through all market conditions, there are limits to this adage. Often times, new traders will come across this advice some time during their education and will interpret it to mean setting a stop at 20 points and an objective 200 points away is a sound strategy. However, the further targets are away from the entry, the longer it will take to close a profitable trade; and conversely, the closer a stop is placed, the easier it will be for an unforeseen jump in volatility to take the trade out. In normal market conditions, this can lead to a low winner/loser ratio; but when price action is as dramatic as it has been recently, this is an especially dangerous strategy. Instead, wider stops can stay with dominant trends but protect against short-term volatility, and closer (but reasonable) targets can be reached before a market stalls or reverses. Ultimately, when considering the risk/reward ratio of a strategy, it is always important to also think about the win/loss ratio to determine whether it will be profitable over the long term.”
Manage your Risk and Cut Back on the Amount of Leverage You Use
“While proper risk management is always important when trading in the forex markets, I think it is even more so when volatility increases. Indeed, with the global credit crunch taking a toll on forex liquidity, currencies are increasingly prone to sharp moves. Here are few methods I’m using to accommodate for these conditions: 1) Set more conservative risk parameters - if you normally use a 2:1 risk/reward ration, perhaps shift to 3:1. 2) Cut back on the amount of leverage you use – it’s great when you can amplify gains, but hurts when it exacerbates losses. 3) Avoid volatile currency pairs, such as GBP/JPY, since price action will likely become even choppier, prone to spikes, and could easily stop you out of your position.”
Adjust your Trading Style to the Current Market Conditions “Given adverse market conditions, traders should consider limiting leverage and avoiding unnecessary risks in today's forex markets. Furthermore, current elevated transaction costs make certain intraday trading strategies significantly less profitable. If a trader goes for 20 pips per trade, currently elevated spreads will quickly eat into trading profits. Consider looking for higher-reward breakout and momentum trades that typically require price extension to become profitable. Given volatility levels, prices are apt to move sharply in either direction for extended periods of time. “
Posted by Antonio Sousa, Chief Strategist Questions? Comments? E-mail: asousa@fxcm.com