Risk Management: The Unsung Hero of Currency Trading
Getting started in the currency markets can initially seem simple, but the vast amount of information available to beginner traders means that it can quickly become daunting. A large number of traders end up "giving up" on their currency market aspirations because the get overwhelmed by the scope of the industry. This is a terrible shame because, at its core, trading in the currency markets is simple.
What it comes down to is an imbalance in how newer traders perceive their journey to market. Far too much focus and time is wasted on analysis, in the sense that people feel they must arm themselves with a wealth of technical tools before they start placing trades. This is simply not true. Any aspiring trader can open a free demo account with a broker, download some free trading software and start trading, risk-free, right away. Furthermore, the quicker a trader starts trading, the quicker they discover the true "holy grail" of the markets; that extensive analysis does not breed success. Instead, success derives from a much simpler concept, one that is much easier to grasp?risk management.
Risk management is a concept that deserves far more attention than it gets. I personally consider it fascinating, and it is the sole element of my trading to which I attribute my success. I implement analysis into my operations, of course, but I believe I could replace my analysis with another approach and replicate the success of my current strategy so long as I maintained its risk management element. Furthermore, I only chose the analysis-type I use as it allows for simple risk calculation and, in turn, minimizes the complexity of my trading.
The first thing I look for when conducting my analysis is a key level. This can be support, resistance or simply a psychologically relevant price, a round number for example. I only look to identify these levels on daily charts, as the higher the time frame, the higher the relevance of the key levels.
I then watch how the price of a pair, normally only the most liquid pairs such as the EURUSD or the USDJPY, behaves around that key level. I watch this price action and the patterns it forms. You can read a little more about the exact patterns I look for in Diary of a Currency Trader, but they are all simple, one, two or three classical candlestick patterns. From these patterns, I form a directional bias, and that's it. Analysis over.
The Exciting Part
This is where the risk management comes in. As aforementioned, my analysis allows for quick and easy risk calculations. They also offer up strict rules to which my strategy dictates I must adhere. Even with my directional bias set, I will not enter a trade unless the pattern adheres to my preset risk parameters.
To give an example, consider one of my favorite patterns?the pin bar. The pin bar is one of the most widely traded candlesticks, and when they form at key levels, they can be a highly reliable reversal signal. The true beauty of a pin bar however, is that they define risk. Take a look at the chart below.
A bearish pin bar is highlighted, having formed at a resistance level that initiated a strong downside reversal. This would alert me to a potential opportunity, and give me a bearish bias, but I would not place a trade until I had established whether the pattern meets my risk requirements. Notice the second key level identified on the chart. Now take a look at the same chart, zoomed in to make the pin bar clearer.
My entry criterion dictate that I know three levels before each trade?my entry point, my loss making exit and my profit taking exit. I only enter trades at the close of a day (NY close), so my entry point is always defined as the close of the pattern I am trading. With a pin bar, I place a stop loss at the end of the tail or wick, for bullish and bearish pins respectively. To find my profit taking level, I identify the next key level in the direction of my bias. In the example, this was a previous swing point that offered up resistance a few months before the pin bar I am trading formed.
Using the example pin, these three levels are 1.0391, 1.0444 and 1.0285 respectively. I then perform a few simple calculations:
1st: Stop loss level - Entry level = Risk
2nd: Entry level - Target = Reward
3rd: Reward / Risk = x
If x >= 2, I enter the trade. If not, I leave it and look for other opportunities. The example shown is both elegant and rare, in that x is exactly 2, but this is not a requirement, more a quirk of the example.
Many will realize that what I am describing here is the requirement that each trade I place affords me a reward to risk ratio of at least 2:1. This concept is nothing new to trading, but it amazes me how few traders adhere to it in their own operations. While it does not guarantee profitability?price must move twice as far in your favor than against you for a profitable trade?it does guarantee that every time you book a profit it will be at least twice as big as your potential loss. This reduces the amount of profitable trades required for long-term success to something just shy or 33%.
All said, next time you look to enter a trade, perform this simple calculation before you hit the execute button. In no time at all, you will be wondering how you ever hoped to grow an account without it. I will leave you with these words: Success in the markets requires three inputs?time, hard work and a sound grasp of risk management principles. In reverse order.
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