Always Place Stop-Loss Orders



The most common and important risk management tool in forex trading is the Stop-Loss order.

A Stop-Loss order ensures a particular position is automatically liquidated at a predetermined price in order to limit potential losses should the market move against your position.

We recommend you always place a Stop-Loss order immediately after a new position is opened, as it can be very tempting to overrun losses on losing trades if a Stop-Loss order hasn't been placed.

So often have I seen situations where a novice trader is 500 points out of the money when he only intended to make or lose 50! By not placing a Stop-Loss order the trader has lost much more than planned, and the Risk/Reward Ratio is exceedingly poor.

In order to avoid this scenario you must follow a simple rule - Always place Stop-Loss orders, liquidity of the Forex market ensures Stop-Loss orders can be easily executed.

Usually Place Take-Profit Orders

Aswell as placing Stop-Loss orders, we recommend in most cases to enter Take-Profit orders at the same time using the OCO order function that most trading systems now have. The reason for this is similar to that for placing Stop-Loss orders.

Whereas with losing positions it can be very tempting to overrun losses, with winning positions it can be just as tempting to lock in a profit too early. By placing limits you will eliminate the risk of not being patient enough and taking profit too early.

However, you may feel confident in your ability not to profit take too early, prefering to monitor the market and taking profit at an opportune moment. In this case placing only a Stop-Loss order is an option.

Positive Risk/Reward Ratio

You should always trade using a positive Risk/Reward Ratio. By a positive Risk/Reward ratio we mean "The amount you're willing to make on a trade should be more than or equal to the amount you're willing to lose".

All successful traders trade using a positive Risk/Reward ratio. There is no sense in having five 30 pip winning trades, and then one 200 pip losing trade because at the end of the day you are 50 pips down!

Unfortunately, many novice and unsuccessful traders use a negative Risk/Reward ratio. When trading this way losing positions are always going to be greater than profitable ones, and it can be difficult to recoup the losses in the short term.

It is not uncommon for unsuccessful traders to increase trade size in order to recoup losses quickly, therefore greatly increasing trading risk relative to trading equity.

This is a recipe for disaster, you must trade with consistancy and control. The easiest way to manage your Risk/Reward is to use the Stop-Loss and Take-Profit orders mentioned above.

Overtrading

Some online forex brokers now offer 3 to 5 pip spreads in the liquid currencies such as EUR/USD and USD/JPY. These are very competitive prices which a few years ago were unthinkable. As recently as the mid 1990's brokers were quoting 10 pip spreads in the major currencies plus a commission!

Thankfully due to the internet, the current boom in Forex trading and the competition between Forex brokers, those days are well and truly over.

The excellent value available from trading on tight spreads works very much to the traders advantage. However, you should avoid overtrading and entering trades for just a 5-10 pip profit or loss. Even trading this way on 3 pip spreads can adversely affect your profitability.

Below are examples of both a winning trade and losing trade when trading for a 10 pip profit or loss:

Winning Trade:

Buy EUR/USD at 1.2020 (price = 17/20)

Sell EUR/USD at 1.2030 (price = 30/33)

Market moves 13 pips before taking profit

Losing Trade:

Buy EUR/USD at 1.2020 (price = 17/20)

Sell EUR/USD at 1.2010 (price = 10/13)

Market moves 7 pips before taking loss

The above example highlights that the risk/reward of trading for a 10 pip profit or loss is poor.

For the same 10 pips P&L, the market must move 13 pips for your winning position, but only 7 pips for your losing position.

As a general rule of thumb, we recommend that your Take-Profit or Stop-Loss levels are at least 10 times the spread you have traded on. This strategy will help avoid overtrading and improve risk/reward.

Chasing the Market

If you are a day trader or short term trader, in general we recommend not to "chase the market".

By this we mean you shouldn't for example buy Euro after it has already risen 100 pips and is trading at the days highs. Or sell USD/JPY after it has come off 150 pips and is trading near the days lows. The rationale behind this is that in many cases the market will consolidate and there will be better opportunities to enter into a new position.

A common scenario when chasing the market is panic buying or selling when a novice trader reverses a position in the hope that they can quickly make back losses. Unfortunately what often happens is that they simply instead end up repeatedly buying the high, and selling the low. This situation must obviously be avoided.

Managing your Margin

We recommend you only risk a maximum of 10% of your total trading equity on a single trade.

10% may sound like too little risk considering many online forex brokers offer 1% margin or 100 times leverage. However, trading on high leverage can be very risky as you could lose everything in a single trade.

By risking only 10% of your equity on a single trade, you will still be able to make good profits from successful trades whilst avoiding the risk of being wiped out during a bad streak.

Even the most profitable traders can have losing streaks in which they could for example have 3 or 4 consecutive losing positions.

Finally

Successful forex trading is a long term investment which can produce excellent returns if traded with control, discipline, patience and consistency. Your target should be to make substancial profits over the course of anything over 3 months.

Wanting to double your money in a week is not the right mindset with which to start trading. The risks involved are way too high and belong in the casino!

In forex trading the old cliche definately rings true -- knowledge equals power!