Risk Management

Profit is the primary motive for all market participants. Just like any other business, where profit is a key objective, traders would be well served by visualizing their trading activity as a business enterprise. Revenue growth in conventional businesses is often driven by a business plan and in trading terms this translates into a trading plan. Analogous to the business world where one would carefully preserve and deploy available resources, this would be achieved in a trading context through the effective management of capital.

Costs in trading terms can be thought of as trading losses, and just as any respectable business plan would include methods for controlling costs, a trading plan would do so by incorporating a methodology for risk management. Moreover, akin to operating procedures related to cost control in a traditional business, the primary mechanisms for achieving the same in a trading environment are position sizing, risk reward ratios and the correct use of stop-losses.

Optimally managing and harnessing human resources is the hallmark of a successful organization, and in a trading enterprise this would apply to traders themselves. Thus, maintaining the right mindset and being able to exercise self-control is an integral part of any trading activity and can be thought of as the key driver of strategy execution and risk management.

The next few chapters deal with these concepts in greater detail. Chapter 2 deals with trading strategy and incorporating a risk management plan into a trading strategy including position sizing and the risk reward equation. Chapter 3 deals with the appropriate use of stop-losses which is a key process in risk management and capital preservation. Chapter 4 deals with a cornerstone of successful trading, often ignored by novice traders, that of the trader’s mindset and the psychology of trading.

Leveraged trading in foreign currency contracts or other off-exchange products on margin carries a high level of risk and may not be suitable for everyone. We advise you to carefully consider whether trading is appropriate for you in light of your personal circumstances. You may lose more than you invest. We recommend that you seek independent financial advice and ensure you fully understand the risks involved before trading. Trading through an online platform carries additional risks. General advice only, not trade advice.

Chapter 1: Trading Strategy Traders will most often employ a simple, step-by-step approach to their interaction with the markets, which ultimately will define their style of trading and will have an impact on their trading mindset. This simple, step-by-step approach would often consist of one or more tried and tested trading strategies, as well as an effective risk management system to preserve or attempt to grow capital. These, along with rules that govern trading behavior, constitute a comprehens ive t rad ing s t ra tegy. In h is conversations with the world’s best traders, Jack Schwager observes,

There are hundreds, if not thousands, of trading methods or strategies that could be applicable to the global asset classes; from strategies centered on seasonality through to purely technical analysis aimed at exploiting a recurring edge on a price chart. This ‘edge’ could exist for a fraction of a second in an arbitrage strategy through to months if not years in more long term swing or positional strategy.

Longevity in the market is often a function of risk management principles. As an example, if a trader had a $1,000 trading account and risked $250 in a single trade; a series of four losses would wipe out the account. However, if the trader risked only $10 per trade, it would take a series of one hundred losses to total $1,000. A rule of thumb commonly applied is to limit risk exposure to no more than 1-2% of the trading account on a trade, and to have no more than 3-5% of your capital at risk at any given time.

Further, erosion of trading capital by a certain percentage requires a larger percentage gain, in order to recoup the loss. A 20% drawdown takes a 25% gain to break even and likewise a 50% drawdown takes a 100% gain to break even.

For example, a 20% loss on a $1,000 account would make the total capital remaining $800; which then would need to be increased by 25% ($200, of $800) to replace the lost capital and total the initial $1,000. This highlights the importance of protecting one’s capital and having a risk management strategy when trading.

A strategy driven approach allows traders to manage emotions. Market participants, who are motivated by excitement, may often find a roller-coaster ride more rewarding and less expensive. Such behavior often encompasses trading that is driven by the emotions of fear and greed which can lead to undesirable outcomes. The best defense against such behavior is to have a robust and sound trading strategy that incorporates financially responsible risk management principles.

The process of trading strategy development in itself often engenders risk management. This is simply because trading strategies imply the creation and deployment of low risk, potentially high reward approaches to trading. While developing the strategy itself, therefore, traders screen out high risk approaches.

Patience is a virtue rings true in any trading endeavor and the ability to wait for ideal setups can have a positive impact on risk. This eliminates low probability trades and allows risk management principles to be applied judiciously. The self-regulatory framework of trading to a plan, reduces the possibility of overtrading, and enhances a trader’s ability to be patient.

Trading without a trading strategy is like building a bridge without a documented plan. Either course of action is likely to lead to unstable outcomes. Although the development of a trading strategy is laborious and time consuming, the resultant trading discipline and risk management that it promotes, through both its development as well as application, may well be worth a trader’s effort.

“A trading plan simply requires combining a personal trading method with specific money management and trade entry rules.” (Schwager).

1-2% A rule of thumb commonly applied is to limit risk exposure to no more than 1-2% of the trading account on a trade

3-5% No more than 3-5% of your capital at risk at any given time

“Market participants, who are motivated by excitement, may often find a roller-coaster ride more rewarding and less expensive”

Examples are not trade advice – information only

Chapter 2: Correct Use of Stop-losses The previous chapter highlighted the importance of a trading strategy and of incorporating risk management principles in the same. This chapter encompasses the appropriate use of stop-losses, which is a key process that a trader may employ to manage risk.

The judicious use of stop-losses can be an effective protection mechanism from allowing losses to run. A big advantage of using stop-losses is that trading accounts do not have to be constantly monitored when a stop-loss is in place. Stop-losses are executed as long as market liquidity exists.

When used correctly, stop-losses can help protect against a large capital loss. Trailing Stops are a useful variation on the traditional, static stop-loss. While static stop-losses trigger at fixed levels, Trailing Stops are defined by a stop distance - when prices move in a favorable direction the

Trailing Stop moves accordingly, but remains stationary when prices move in an unfavorable way.

Where then should stop-losses be set? This will depend on the trading strategy you have created. A general rule of thumb could be to set it at the point where the trade premise would be invalidated. In other words, the point at which the trader’s reading of market direction would be proved incorrect. For example, a long position in an uptrend may have a stop placed below the most recent swing-low; since movement below this level would invalidate the premise of a sequence of higher-highs and higher-lows.

There are a number of methods to select appropriate exit levels, among the more common ones are based on a fixed percentage at risk, volatility analysis and/or technical levels. Finding the right method for you is dependent on your individual trading style, plan and risk appetite.

Stop-losses help preserve your capital. Their use is important because without capital you can not trade.

“Trading currencies and most other financial asset classes usually involves the use of leverage which can be a double edged sword as leverage amplifies profits but also magnifies losses”

Using a fixed percentage of risk for your Stop-loss Our fxTrade p la t fo rm is designed with a number of important risk management tools to assist you in placing stop- losses. Our fxTrade platform has the ability to calculate a Stop-loss and you can automatically have a stop-loss for each new trade if you specify it in ‘user preferences’.

To view all the options available to you for setting default trade settings, click on the Tools menu on fxTrade, select User Preferences and click on the Trading tab.

For example, a trader with $10,000 in their account might wish to set the initial stop-loss order to be no more than 2% of their capital, or $200. If the trader selected a default position size as 5% of their leveraged NAV, the platform would automatically select a position size and a stop-loss level that would equal or be as closely equal to their potential desired risk level as possible, based on current pricing:

Please note you can set default stops based on a set number of pips, as a percentage of your balance (% balance), as a percentage of your Net Asset Value (%NAV) or fixed value of your account currency. The function of determining a stop-loss based on a percentage of NAV or Balance only works in conjuncture with setting a default position size.

Benefits to selecting position sizing based on a percentage of your Balance or NAV: ►  If you suffer losses, your position sizes will decrease

helping you to preserve capital.

►  As your capital grows, this will assist you in gradually increasing your position size while maintaining the same percentage risk levels

Past performance is not indicative of future results.

Past performance is not indicative of future results.

Setting your exits on price volatility When working out your exit from a trade whether it is your stop-loss or take-profit, it is important to keep in mind the volatility of the market you are trading. Put simply, volatility is the amount a price can potentially move over a period of time and knowing this can assist you in avoiding your exits from being triggered too early.

You can use technical indicators which illustrate price volatility such as Average True Range (ATR),

Bollinger Bands or volatility tools such as our Value at Risk (VaR) calculator or the Volatility analysis chart provided by Autochartist to assist you in understanding these price movements.

For example, if a trader was looking at a 15 minute chart of EUR/USD and wanted to enter a trade, they could reference the Volatility Analysis section of our Technical Analysis powered by Autochartist for an expected volatility range:

In the above image, Autochartist has calculated that within 68% probability the potential price range for EUR/USD, for a 15 minute time frame, falls between the prices of 1.1317 to 1.1326 for the expected period of time. Thus, if the trader placed their exits within this range there is a higher probability they may be triggered.

Please note there is always the possibility of the market moving beyond the estimated amount shown. In various markets, major economic events can cause a steep rise or fall of prices in a short period of time. Therefore, it is highly recommended to take additional measures into account when assessing the risk associated with trading.

Past performance is not indicative of future results.

Find out more about using the volatility analysis in your trading by watching the following short video.

Yo u c a n a c c e s s y o u r Autochartist portal by clicking the Technical Analysis icon located on the fxTrade platform or you will also find it under the Resources menu:

Using Technical levels for your exits Another method for setting stop-loss levels (as well as take-profits) is at key technical levels such as support/resistance, pivot-points or Fibonacci levels.

One strategy used by some traders is to use Fibonacci Retracement levels as guidelines for placing stop-loss orders. For example, when prices are trending upwards and you hold a long position,

one consideration is to place the stop-loss just below the latest swing low rate. Because the swing low rate sometimes becomes a level of support, a falling price may recover before it actually falls through a previous support level.

Setting the stop-loss below the support level minimizes the potential loss as the stop-loss is only triggered if the exchange rate falls below an established support level.

Past performance is not indicative of future results.

In the example above, the stop-loss could be positioned below the support and resistance level which will be at the swing low of the uptrend should the trade move in the intended direction. Protection would be offered by the 50% and 61.8% Fibonacci levels as well as the big number of 1.0900.

When trading in a downtrend and you are short the currency pair, the usual approach is to set a stop-loss just above the swing high as this could represent a potential resistance level.

Once again, the thing to remember is that the rate may retrace back to the swing high but is less likely to exceed it. Therefore, setting the stop-loss above the resistance level means the stop-loss will only be triggered if the resistance level is broken.

Stop-losses in practice Once set, stop-losses should generally not be moved away from the trade direction, as this action does not constitute good risk management practice. However, if a position moves in a trader’s favor, and subsequent price action indicates a new logical level consistent with the trade premise, then a trader may consider moving the Stop to a new level. For example, if a trader was long in an up trending market, they may consider moving the stop-loss to the next higher swing low; once it has clearly formed. Some traders prefer to not enter stop-losses on their orders and instead execute them manually.

This requires constant monitoring in addition to immense self-discipline and is best undertaken only by very experienced traders who are able to closely follow their positions.

An unfortunate fact of trading is that gaps occur in pricing. A gap can be caused my many factors and can occur in the direction of the current market direction, as well as against it. If a trade is open and prices gap against the trade’s direction, the stop-loss would be triggered at the next available price point. In such a situation there may be a difference between the point at which a stop-loss was set and the price at which it was actually executed. This difference is commonly referred to as slippage and is an unavoidable risk of trading.

Trading, in essence, is an activity governed by probabilities. While one can and should stack the probabilities in their favor by adopting an appropriate trading strategy, there are no guarantees that the market will behave as predicted. Thus, even the most reliable strategy, when executed flawlessly, may result in negative outcomes. Stop-losses are a mechanism that can provide traders a method of preserving their capital. One cannot trade without capital.

“Best-practice generally calls for the use of automated stop-losses via order tickets at the time a trade is setup”

Past performance is not indicative of future results

Trade Entry

Stop-loss

Support and Resistance Level

Fibonacci Retracement

Chapter 3: Trader's Mindset

Impulse-trading and revenge-trading are two self-sabotaging behaviors noticed in some traders. Impulse trading involves taking trades without adequate deliberation and analysis. Revenge-trading involves re-initiating a losing trade driven by the frustration of having being proven wrong by the market. Both of these may also involve taking low percentage and high-risk trades to recoup losses. These behaviors can be explained by the fear-greed theory, as well as Mark Douglas’ classification of fears.

The market is always right and it will do what it wants to do regardless of a trader’s own beliefs,

wants and desires for the market. In order to better manage risk, a trader will need to accept and internalize this fundamental axiom of trading. Though traders cannot control what the market will do, they can control what they themselves will do next. Overcoming fears by accepting that losing trades are not a reflection of one’s shortcomings as a person, but rather an immutable by-product of the trading business, can help one to operate within the parameters of their risk management plan, with focus on capital preservation and attempt to control the negative impact of risk to their trading accounts.

“In the market, the fear of losing one’s fortune is every bit as intense as the fear of losing one’s life. The best traders aren’t afraid.” (Douglas, The Disciplined Trader).

Trading can be thought of as a series of independent trade events; with one connection between these events being the trader him/herself. Thus the psychology of the trader, his mindset, is one of the key determinants of the outcome. The two primary emotions underlying a trader’s mental makeup are fear and greed (Elder). A similar sentiment is echoed by Mark Douglas,

Coupled with the instinctive fight or flight instinct that we as humans have, fear and greed can make us react in ways that often restricts us from effectively managing market risk.

Given the self-evident nature of the adage relating to letting profits run and cutting losses short, why is it so difficult to abide by? Mark Douglas identifies four kinds of fears that traders have. They are: losing; being wrong; missing out;

and leaving money on the table (Douglas, Trading in the Zone), which covers the fear-greed continuum experienced by traders.

Honest introspection would in all likelihood lead us to conclude that the reasons we move our stop-losses, or in some cases trade without one, thereby allowing losers to run, is governed by the first two fears identified above, losing and being wrong. Importantly, one’s perception of reality is conditioned by what we believe or want to see. The ‘buy, hope and pray’ trading strategy could be related to this behavior.

For example, price action may clearly indicate an uptrend, while the trader who has a short position open perceives (and thus believes) that the market will soon correct downwards. On seeing a normal counter trend retracement their hopes rise and their belief is reinforced.

Moreover, many traders are affected by the endowment effect. This means they develop an unhealthy attachment to their trades and keep them open longer than they should. This will likely lead to a significant loss in their invested capital, not allowing for future trades to occur. Traders need capital to trade, which is why it needs to be protected.

Summary The objective of trading can be either capital growth or cash flow generation; both of these, by definition, require an initial capital investment. By implementing a risk management plan, Traders can preserve and protect their capital. A risk management plan, as we have seen in the preceding chapters includes the implementation of a well thought out and documented set of rules with capital preservation as one of its primary objectives.

Should you have any further questions and need assistance in any way, please contact your local OANDA representative at http://www.oanda.com/corp/contact/.

Works Cited

Douglas, Mark. The Disciplined Trader. New York Institute of Finance, 1990. Print. Trading in the Zone. New York Institute of Finance, 2000. Print.

Elder, Alexander. Trading for a Living. John Wiley and Sons, 1992. Print.

Schwager, Jack D. The New Market Wizards. Harper Business, 1992. Print.