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How to Manage Risk with Price Action

How to Manage Risk with Price Action

2014-09-18 19:00:00
James Stanley, Strategist
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Talking Points:

  • This article is part 3 of our ‘How to Trade with Price Action’ series.
  • In this article, we show traders how to let losing trades manage themselves so traders can focus on managing winning positions.
  • Traders can let price action make the trade management decisions for them.

In our previous two articles, we looked at piecing together the various aspects of price action analysis in the effort of creating a ‘well-rounded’ approach.

In our first article, we looked at how traders can diagnose and identify market conditions so that they can decide how they’re going to approach that specific market.

In our second piece, we took this a step further by showing ‘how’ to implement the trade idea/plan based on the analysis from the first step.

In this article, we’re going to round out the topic by looking at what many traders consider to be the most important aspect of a trading approach: Trade and risk management.

The Best Part about Price Action

This is something that I’ll commonly reference during price action webinars in DailyFX PLUS, but one of the most alluring parts of price action isn’t necessarily what it does for us as much as what it doesn’t do.

And what it doesn’t do is offer signals – or direct messages as to ‘when’ to take a position. Price action is purely analytical in nature.

This can be daunting for new traders because price action is subjective (and it takes some time to learn); but it can be hugely beneficial for traders that actively look to avoid The Number One Mistake that Forex Traders Make.

Summarily – Price Action analysis can help traders get the cleanest and most clear picture of current technical levels in the effort of finding strong risk-reward setups.

Whereas indicators like RSI or MACD trigger off signals that will inevitably, at times, be wrong – price action merely shows traders that they may be able to buy support in an uptrend so that if a trend or a theme is to continue, the trader can make three, four, or five times the amount they had to risk.

This isn’t to say that indicators are worthless, because they are not. But they have to be taken with context, and for technical traders that’s not usually a luxury that is afforded.

So, as we get into the topic of trade and risk management with price action, it’s important to remember some key variables.

Regardless of how great of a trader you ever become or how strong your analysis might be – you will never be able to predict the future with 100% accuracy… so proper risk management is actually a lot closer to a necessity than a preference.

We saw the banes of risk management in our Traits of Successful Traders series. This is often the differentiator between a professional trader and an amateur, as evidenced in the article The Number One Mistake that FX Traders Make.

Therefore, the best part about price action is that it offers a clean, clear, and concise picture of a market’s dynamics at any point in time relevant to its past performance. This helps greatly with risk management identification so that traders can look to avoid The Number One Mistake that FX Traders Make.

Look at Risk as a Cost of Doing Business

As a trader, it’s our job to take opportunities with the goal of making money if the position is to work out. This isn’t dissimilar than many other small business owners that need to purchase inventory in order to sell products to customers. This inventory has a cost, and the business owner wants to sell it at a higher price than they paid so that their business can make money.

But just like small business owners will find products they can’t sell, traders are going to have trade ideas and positions that don’t work out so well.

So, before ever placing a trade – traders need to look at how much it might cost them if that idea doesn’t work out.

We touched on this in our last article, but price action can afford the luxury of being able to easily see how much it might cost to trade on that theme.

For example, if a trader wants to look for a trend continuation move in USDJPY, they can line up the chart to identify the previous swing-lows in that market. If this up-trend is to continue, then previous swing-lows should remain respected. So, if one wanted to buy the up-trend in USDJPY, they can look to place their stop below one of the previous swing lows. The chart below helps to identify these points of reference.

Trade like a Small Business Owner

How to Manage Risk with Price Action

Created with Marketscope/Trading Station II; prepared by James Stanley

Now that the trader knows how much trying to buy this trend might ‘cost,’ they can look at the potential for reward (or winning) to more properly decide if they want to take that trade.

In this particular example, current price is about ~175 pips away from the most recent swing low (in the 107 area on the chart above). The ‘more conservative’ stop (further away) is in the ~106 neighborhood, or ~275 pips away from current market price.

Further, traders may notice the wicks taking place on the past two four-hour candles, highlighting the fact that selling is coming in as USDJPY rips to new highs: Meaning this opportunity may not be so attractive right now.

Rather, traders may look to wait for price to come closer to one of these previous swing-lows in an effort to buy USDJPY more cheaply. Further, by waiting, the trader may be able to get a ‘higher-low’ in the up-trend that could afford a cheaper stop.

After all – it is MUCH better to miss out on a trade opportunity than it is to lose capital: Because opportunities in trading are infinite while trading capital is anything but.

The big question to ask after identifying risk amount is whether or not the potential for reward warrants the cost of the position. If it reward potential doesn’t warrant the ‘cost’ of the entry, simply avoid placing the trade.

If you want to learn more about risk identification via price action, the article How to Analyze and Trade Ranges with Price Action discusses the range-bound condition, while the article How to Attack Trends Using Price Action discusses trending conditions.

Trade Management

Traders often fail to give trade management proper credit or focus. In many cases, traders avoid having a plan as to how they manage trading positions; meaning they go by ‘gut instinct’ or ‘reactions.’

This can be dangerous. This means that traders can often suffer from the greed/fear paradox.

Keep in mind; you have the same chance of predicting the future whilst in a position as you do before entering; which is to say you pretty much can’t.

There is an old saying in markets: ‘traders manage winning positions; losers manage themselves.’

Meaning: Place a stop on the position and if the trade doesn’t work out, move on to the next opportunity. If it does work out, then that’s when you get to do your job as a trader by managing your risk.

This is where traders can begin to scale out of the position in an effort to get as much as possible out of the move. After all, if you’ve been successful in this trade idea thus far, you may be able to be even more successful by holding a piece of the position. On the other hand, if you don’t scale out at least a portion of the trade you run the risk of losing some or all of the floating gain.

Traders can also look to move their stop to break-even so, at the least, they can look to avoid taking a loss on the remainder of the position should the move fail to continue. In the chart below, we take a look at a trade that I’ve been discussing in our price action webinars in DailyFX PLUS over the past couple of weeks in USDJPY.

After the seven-month range was confirmed as broken, I was able to get a long entry at a higher swing-low. After a ~190 pip gain, I was able to get a second entry at the next swing-low.

As the pair rips to new highs, I’ve begun to ‘scale-out’ of the first position, while moving the stop on the net position deeper in the money. That way, if this move turns around – I can bail out before I have to take a loss on the rest of the trade. But should the move continue, I’m able to remain in a position where I can take part in some of those additional gains.

Letting Price Action Make your Trade Management Decisions

How to Manage Risk with Price Action

Created with Marketscope/Trading Station II; prepared by James Stanley

While none of this is a panacea that will always work, trading is about concentrating on probabilities. This type of trade management allows traders to keep losses mitigated while concentrating on winning positions when they’re right.

--- Written by James Stanley

Before employing any of the mentioned methods, traders should first test on a demo account. The demo account is free; features live prices, and can be a phenomenal testing ground for new strategies and methods. Click here to sign up for a free demo account through FXCM.

James is available on Twitter @JStanleyFX

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