Chapter 13

Risk-Management Considerations

In This Chapter

Understanding the different types of risk

Managing leverage and inflated expectations

Setting up trade plans in terms of risk

Planning for the unexpected

Trading is all about risk, yet it’s frequently the last thing many individual traders think about. Too often, they’re fixated on the expectation of positive trading results, as in “How much can I make?” To a large extent, that’s basic human nature. Why would anyone speculate in anything unless he believed he could win?

We think traders should approach the forex market with eyes wide open when it comes to the risks they’re taking. And we’re not talking about some simple risk formula that comes out to dollars and cents. We’re looking at it from the perspective of an overall risk-taking enterprise philosophy. The more aware you are of the risks you face in the forex market, the more likely you’ll be able to avoid them — and the more likely your success.

Managing Risk Is More Than Avoiding Losses

On the most basic level, risk in currency trading is the same as trading in any other financial market — the risk is that you’ll lose money. But risk comes in many different forms and from many different sources. Sometimes the biggest risks are the ones that you never knew existed.

We believe forewarned is forearmed. In this section, we look at some of the main sources of risk that may not be readily apparent or that are easily overlooked.

Leverage amplifies gains and losses — and expectations

Leverage refers to the multiple applied to your available margin collateral, which translates into the maximum size of your market position. Leverage is typically expressed as a multiplier rate (like 10 times or 20 times) or a ratio (like 10:1 or 20:1). If the leverage rate is 10-times/ratio is 10:1, for example, and you have $1,000 of available margin, you’re able to hold a maximum position equal to $10,000.

Online currency trading firms typically offer higher leverage ratios than you may be familiar with from trading stocks on margin. Leverage ratios among currency brokers are typically on the order of 100:1 for standard-size accounts (100,000 trade-lot size) and 200:1 for mini-accounts (10,000 trade-lot size). Recent regulatory changes around the world have limited maximum leverage ratios to lower levels, such as 20:1 in Hong Kong or 50:1 in the United States, which we think is more than sufficient for individual traders.

Be wary of forex brokerage firms that offer super-sized leverage. We’ve seen some offering up to 400-times leverage, or 400:1. We strongly discourage you from employing that much leverage. As well, regulatory limits on leverage have seen some traders go jurisdiction shopping, looking for the highest leverage available, but ending up in dodgy locales that may carry additional risks.

Leverage is a great trading tool, allowing traders with less capital to participate in markets that they couldn’t trade otherwise. But leverage is still just a tool. As with any other tool (think of a chainsaw here), if you learn how to use it properly, you’ll be able to get the job done faster and easier. But if you don’t learn how it works, and respect it, you’re asking for trouble.

Most people see only the upside benefits of leverage — the larger the position on a profitable trade, the larger the profit, right? Yes, leverage will magnify your gains, but it’ll also magnify your losses — the larger the position on a losing trade, the larger the loss you’ll experience. You need to have a healthy respect for the downside risk in trading, or you won’t last very long.

Take an example of a $100,000/lot-size account with $10,000 in initial margin deposited at a 50:1 leverage ratio. That margin balance translates into a maximum position size of $500,000, or five lots. If you were to take a position in USD/JPY at 90.00 using the maximum position size available, every pip change in USD/JPY is worth about $55.55 ([$500,000 × 0.01 pips] ÷ 90.00 = $55.55). But USD/JPY is regularly subject to 50- to 100-pip price swings in a single day (or more). If you’re positioned the wrong way, you could lose around $2,778 to $5,555 in the course of a normal, run-of-the-mill trading day. That’s about 28 percent to 55 percent of your trading capital in just one trade!

The key here is to avoid being seduced by leverage. Just because you’re able to get 100:1 leverage doesn’t mean you have to use it all. Trading a larger position may seem sexy, but no one ever said prudent, risk-aware trading was supposed to be sexy. Use leverage as a tool to facilitate your trading strategies, not as an ego booster.

Knowing your margin requirements

Online forex brokers require margin posted as collateral to cover any losses on your trading account. To protect themselves from client losses eating up the entire margin (or going negative) in adverse market movements, online brokers typically require you to have 100 percent of available margin for any open positions.

For example, at 50:1 leverage, if you’re holding a $100,000 position in USD/CHF, you’ll need to have at least $2,000 of available margin to hold the position ([$100,000 ÷ 100] × 0.50 = $500). If your available margin balance falls below $2,000 at any time, even for a second or just by pip, your broker has the right to liquidate your position, which is a fancy way of saying it closes out your position for you. Your losses are locked in, and your available margin balance is reduced.

Margin balances are typically monitored by computer programs based on current market prices. If a price move causes your available margin to fall below the required level, the position will be closed — no margin call, no notification to you, just a liquidated position. You may think that’s unfair, but the reality is that brokers need to liquidate losing positions at some point, or your loss will become theirs.

As a trader, it’s your responsibility to read the fine print and to know the minimum margin requirements and liquidation policies before you start trading. Regulated forex brokers must disclose their policies in your customer account agreement.

Liquidation policies can vary among brokers with some closing all open positions at once (in the case of multiple open positions) and others closing the largest losing position first until the minimum requirement is met to close remaining open positions.

From a trader’s perspective, you never want to be in the situation where your positions are liquidated due to insufficient margin. It means you’re trading too large a position for your available margin or you’ve let the losses run for too long relative to your available margin. Each trade plan needs to factor in the minimum margin requirement, and it should never even come close, or you’re better off with a smaller position size. We look at the critical relationship between position size and margin later in this section.

Market liquidity, volatility, and gap risk

The forex market is routinely described as the most liquid financial market in the world, and that’s true. But it doesn’t mean that currencies are not subject to varying liquidity conditions.

Liquidity refers to the amount of market interest (the number of active traders and the overall volume of trading) present in a particular market at any given time. From an individual trader’s perspective, liquidity is usually experienced in terms of the volatility of price movements. A highly liquid market will tend to see prices move very gradually and in smaller increments. A less liquid market will tend to see prices move more abruptly and in larger price increments.

Shifting liquidity conditions can increase volatility

Forex market liquidity will vary throughout each trading day as global financial centers open and close in their respective time zones. Reduced liquidity is first evident during the Asia-Pacific trading session, which accounts for only about 21 percent of global daily trading volume. Japanese, Chinese, or Australian data or comments from regional finance officials may provoke a larger-than-expected or more-persistent reaction simply because there is less trading interest to counteract the directional move suggested by the news.

Peak liquidity conditions are in effect when European and London markets are open, overlapping with Asian sessions in their morning and North American markets in the European afternoon. Following the close of European trading, liquidity drops off sharply in what is commonly referred to as the New York afternoon market.

During these periods of reduced liquidity and interest, currency rates are prone to drift in narrow ranges, but are also subject to more sudden and volatile price movements. The catalyst could be a news event or a rumor, and the reduced liquidity sees prices react more abruptly than would be the case during more liquid periods.

Another common source of erratic price moves during less liquid periods is short-term market positioning. A classic example is a strong rally in a currency pair during the North American morning/European afternoon. As Europe heads home, the currency pair typically settles into a consolidation range near the upper end of the day’s rally. If sufficient short positions have been established on the rally, further price gains may force some shorts to buy and cover. With reduced liquidity, prices may jump abruptly, provoking a flood of similar buying from other shorts, resulting in a short squeeze higher.

The same phenomenon can occur following market declines, where market longs are forced to exit in a rush on further price declines. Still another variation on this theme is sharp price reversals of an earlier rally, where longs take profit in thin conditions and the resulting price dip brings out selling by other longs rushing to preserve profits. After a sell-off, profit-taking on short positions can provoke a sharp short-covering reversal.

There’s no way to predict with any certainty how price movements will develop in such relatively illiquid periods, and that’s the ultimate point in terms of risk. The bottom line is that if you maintain a position in the market during these periods of thin liquidity, you’re exposed to an increased risk of more volatile price action.

Liquidity is also reduced by market holidays in various countries and seasonal periods of reduced market interest, such as the late summer and around the Easter and Christmas/New Year holidays.

Typically, holiday sessions result in reduced volatility as markets succumb to inertia and remain confined to ranges. The risks also increase for sudden breakouts and major trend reversals. Aggressive speculators, such as hedge funds, exploit reduced liquidity to push markets past key technical points, which forces other market participants to respond belatedly, propelling the breakout or reversal even further. By the time the holiday is over, the market may have moved several hundred points and established an entirely new direction.

Just because you’re enjoying an extended holiday weekend doesn’t mean you’re not exposed to risk from higher volatility in holiday markets. You are — and you need to factor liquidity conditions into your overall trading plan.

Getting a handle on volatility

Volatility is a statistical term referring to price fluctuations (standard deviation) relative to the average price over a specified period of time. Volatility is what makes the trading world go ’round, and without it, speculators would have a lot of time on their hands.

But not all volatility is created equal, and you need to be aware of two main types of volatility that can alter the currency playing field:

• Market volatility: Market volatility is the overall level of price volatility in various financial markets at any given time. The VIX S&P 500 volatility index is a good overall barometer of market volatility. Market volatility typically increases during periods of uncertainty or unexpected economic data or monetary policy developments. If you’re trading on a short-term basis or using a model that relies on relatively low volatility (for example, mean reverting systems, moving averages, or regression channels), you need to be aware that increased volatility can quickly swamp such strategies. Better to stay on the sidelines and sit out the upheavals than jump in with a strategy unsuited to higher volatility.
• Currency-pair volatility: Different currency pairs trade with different volatility characteristics, both in the short and long term. Before you go with a trade setup in a currency pair you’ve spotted on a chart, make sure you’re aware of the pair’s relative volatility. (We discuss individual currency-pair volatility and other trading characteristics in greater detail in Chapters 8 and 9.)

Minding the gap

Gap risk refers to the potential for prices to gap, or jump from one price level to another with no tradeable prices in between. Gap risk typically is associated with events such as economic data reports, central bank rate decisions, and other major news events. In that sense, most gap risk is identifiable in advance by looking at data and event calendars. Unexpected news or official comments can also trigger price gaps. Breaks of key technical levels are another source of price gaps.

Gaps vary in size depending on the nature of the news, but price gaps of 20 to 80 pips or more are not uncommon in currencies after major news and data events. Gaps occur because the interbank market reduces its bids and offers in the minutes or so immediately before and after major announcements, leaving online currency trading platforms with no prices to show individual traders.

After the news is out, interbank traders adjust their prices to reflect the news, resulting in a price gap higher or lower. It may be up to 30 seconds (or more depending on the news or event) before normal pricing returns.

If you’re holding open positions at the time of major data releases or events, you’re subject to gap risk. The same goes for stop-loss orders left with online brokers — stop-loss executions are subject to gap risk. Depending on market circumstances, stop-loss order executions will see slippage (meaning, your stop-loss order may not be filled at the rate you specified). In the case of price gaps, brokers are obligated only to fill your order on a “best efforts” basis.

Don’t expect to be able to leave a stop-loss order nearby on either side of the market before a major news or data event and have it filled at your order rate. Occasionally, the market will take out both sides of the stop-loss orders before the release ever hits the market, locking in your loss. If that doesn’t happen, and the market gaps through one side of your order, you’re subject to slippage, and you’ll be filled where the market resumes trading, which could be substantially different from where you left your order.

If you’re thinking that this is some trick that online brokers cooked up to sock it to individual traders, keep this in mind: The big players in the interbank market are subject to the same gap risk as individuals trading online. Even if you were a prop trader (see Chapter 3) at some big bank, with one of your own bank’s traders watching your order, you’re going to get filled where your trader is able to execute the order in the market. The same applies to online brokerages. Bottom line: No market-maker will survive very long if he fills his customers at rates even he can’t access.

The other type of gap risk stems from events that occur over weekends, potentially resulting in a substantial gap between Friday’s closing level and the Sunday/Monday opening price. Weekend gap risk is typically also identifiable in advance because it most often occurs around scheduled events like a G20 meeting or a Chinese data release.

That said, there’s still plenty of potential for unexpected events (earthquakes, terrorism, and currency revaluations or devaluations, to name just a few) to happen over weekends. To judge the risks of a weekend gap, you need to have a good sense of what’s going on in the major currency nations and a healthy sense of expecting the unexpected. The safest approach is simply not to hold positions over a weekend.

We have a winner here! Protecting your profits

It’s one thing to speculate in the market and get the direction wrong. That’s good old-fashioned risk-taking, and it’s just part of the business of trading. But it’s another result entirely to get the direction right and still lose money, or not make as much as you could have, or not keep as much as you’d already made.

Most traders can readily accept the idea of getting the direction wrong. They shrug it off and get back to work in short order. But take a trader with a winning position in the morning that goes south in the afternoon, and you’re suddenly looking at a case study of negative trader emotions. With a wrong-way trade, it’s a simple case of not missing what you never had. With a good trade gone bad, it’s hard not to feel regret or think the market is out to get you.

Experienced traders know that keeping what you’ve made is often as hard as making it in the first place, so they guard their profits aggressively. The best way to do that is by adjusting your stop loss in the direction of the trade once it’s in the money. You can do this by using either a trailing stop loss or manually changing your original stop loss based on specific price levels being surpassed.

A trailing stop loss is a stop-loss order that automatically trails the market at a user-defined distance (say, 40 pips). For example, if you’re short at 55, and you have a 40-pip trailing stop loss, the stop starts out at 95. As the market moves lower, the trailing stop will adjust so that it is always 40 pips from the low. If the market trades down to 10, your trailing stop is now at 50, guaranteeing you at least a 5-pip profit. Trailing stops are great for catching longer-term movements, because they rely on a market reversal of x pips before being triggered.

If you’re more inclined to trade according to technical levels, you may want to consider manually adjusting your stop loss after specific levels are broken. For example, if you’re long, you may raise your stop loss from its original level after technical resistance has been broken.

Above all, if the market reverses and your profit starts to decline, don’t worry about getting back what you’ve just lost — worry about keeping what you’ve still got.

Placing your orders effectively

Currency traders rely on orders to take advantage of price movements when they’re not able to personally monitor the market and also to protect themselves from adverse price movements. If you’re going to be trading currencies, odds are that you’ll be relying on orders as part of your overall trade strategy. We cover the various types of orders in greater detail in Chapter 4.

The two main types of orders are limit orders, used to buy or sell at rates more favorable than current market prices, and stop-loss orders, which are used to buy or sell at worse rates than prevailing levels. The key difference between the two types is that you generally want your limit orders to get filled, but you don’t want your stop-loss orders to be triggered. That’s because limit orders are used to take profit and enter positions (which you want), and stop-loss orders are used mainly to exit losing positions (which nobody likes). (The exception is stop-loss entry orders, in which you use a stop-loss order to enter a position — on a breakout, for example [see Chapter 14].)

The risk with using orders is that you miss having your take-profit limit or entry orders filled or that your stop-loss orders are triggered at extreme price points. The catch here is that markets have a penchant for going after stop-loss orders and shying away from limit orders in the routine noise of daily fluctuations.

That makes where you place your orders a critical factor in your overall trading strategy. Deciding where to place orders is definitely more art than science, and even the most experienced currency traders continually grapple with the question of where to place their orders.

Factoring in the dealing spread with orders

Online currency traders face two other complicating factors: the dealing spread of the currency pairs and the order execution policies of online currency trading platforms.

Most online platforms execute on the basis that a limit order to sell is filled when the bid price reaches the order rate and a limit order to buy is filled when the offer price reaches the order rate. In the case of stop losses, a stop-loss order to sell is triggered if the bid price reaches the order rate, and a stop order to buy is executed if the offer price reaches the order rate. In both cases, the dealing spread works against the order, and traders need to take that into account.

For example, you may be long USD/CHF at 1.0250 with a limit, take-profit order, to sell at 1.0330 and a stop-loss order to sell at 1.0200. For your take profit to be executed, the dealing price must print 1.0330/33. If the highest price quoted is 1.2329/32, no cigar. Your stop loss would be triggered if the dealing price ever trades at 1.0200/03; if the lowest quoted price is 1.0201/04, your order is still alive. As you can see, it’s frequently a game of inches played out in milliseconds.

Factoring in technical levels when placing orders

Many traders focus on technical levels to decide where to place their orders. Continuing the order example from the last section, if there is resistance from a trend line or hourly highs at the 1.0330 level, many other sell orders could be grouped there. If the selling interest is strong enough, the market may never get that high because sellers step in front of the resistance level, start selling, and stop prices from rising.

In the case of the stop-loss level, it may be placed on Fibonacci retracement support or recent daily lows, which may also attract other technically minded traders to place their stops at the same level. If the market starts to move lower, sellers will frequently try to test key technical-support levels to see if they hold, in the process triggering stop-loss orders left at those levels. The stops may be triggered and the level exceeded briefly, only to see prices rebound and the support ultimately hold.

Getting stopped out at a market top or bottom is a very frustrating experience, but it’s happened to everyone at one point or another. Remember: Someone has to sell at the low and buy at the high.

Margins of error and market extremes

One way to prevent getting stopped out by market extremes is to factor in a margin of error when placing your orders. Using a margin of error is a fairly sophisticated practice, but the idea is to err on the side of getting your limit order filled — leaving a sell order a few points below key resistance levels or a buy order a few points above support levels. At a minimum, the margin of error should account for the dealing spread of the currency pair you’re trading.

For stop losses, the concept is to err on the side of not allowing your stop to be triggered — leaving a stop-loss sell order several points below key support levels and a stop-loss buy order above technical resistance levels.

In both cases, the margin of error will depend on the relative volatility of the currency pair you’re trading as well as overall market volatility at the time. Generally speaking, the greater the volatility, the greater the margin of error, and vice versa. (We look at individual currency pair volatility and trading behavior in greater detail in Chapters 8 and 9.) Our own preference for limit orders is for a small margin of error of around 5 to 10 pips. For stop losses, we like to use a wider margin of error of around 20 to 40 pips, allowing for a greater cushion in case others’ stops get triggered and the technical level is briefly broken.

Using a margin of error in placing orders will also require you to rethink the overall trade strategy, especially in terms of position size. If you’re going to place stops with a margin of error, and the stop ends up getting triggered anyway, your losses will be greater. So you may need to reduce the position size to mitigate the impact on your margin.

Placing stop-loss orders based on technical or financial levels

There are generally two schools of thought when it comes to the basis for deciding where to place stop-loss orders:

• Technical stops: Placing a stop-loss order according to price levels identified through technical analysis. Whatever technical approach you choose to follow, you’ll be looking to identify key technical points that, if exceeded, will invalidate the trade setup and signal that it’s time to get out of the trade.
• Financial stops: Based on the amount of money you’re prepared to risk on a given trade. You may base the trade on a fundamental view of future developments, but you’re willing or able to risk only a certain amount of money on the trade.

Financial stops may be appealing to highly conservative traders who don’t want to risk more than a fixed amount on any single trade. If that’s your way of maintaining trading discipline, by all means go with it. But we think it’s important to note that financial stops are essentially arbitrary and have no relation to the market. They’re much more a function of position size and entry price — elements you control — than any objective market measure.

Technical stops, on the other hand, are based on past price action, which is about the only concrete way traders have of gauging future price movements. If GBP/USD has repeatedly failed to trade above 1.6215 in recent weeks, to pick a random price as an example, a move above that level suggests that something has changed. And the market, in its infinite wisdom, has decided that GBP/USD should move higher. We have no way of knowing for sure whether the break will be sustained; we can only go with our best analysis.

Our own preference is to base orders on technical levels rather than financial considerations, but the ultimate limiting factor is the amount of money at risk. That may sound like we’re trying to have it both ways — we explain this idea further in the next section.

Applying Risk Management to the Trade

When it comes to trading, risk management is frequently an afterthought — that is, until you take a loss that you weren’t expecting. Suddenly, the wisdom of the ages is upon you, and you vow never to let it happen again.

By the way, who in her right mind would ever put on a trade expecting to take a loss, anyway? Sounds crazy, right? But all the experienced traders we know calculate the risk they’re facing in every trade before they ever enter it. It’s part of their decision-making DNA and goes a long way to determining which trade opportunities they pursue and which ones they skip.

We strongly recommend that traders approach the forex market with risk management as the first thought. It’s how you’ll be able to get some trades wrong and still survive to get other trades right.

Analyzing the trade setup to determine position size

The starting point for any successful trade is developing a well-conceived trading plan. And the most important element of a trading plan is the size of the position that will be traded. Position size will determine how much money is ultimately at risk, as well as the overall viability of the trade.

But position size is only one half of the equation that determines how much money is at risk. The second half of the equation is the pip distance between the entry price and the stop-loss level. Wait a minute, you may be thinking. Why didn’t we mention the upside potential or the pip distance between the entry price and the take profit? Why aren’t we looking at how much money we can make on the trade?

Save the rose-colored glasses for buying lottery tickets. When you’re plunking down a dollar or two, it’s okay to focus only on the upside and dream about winning millions. But when you’re trading in any financial market, you have to remember the market is not there to give you money.

We know you’re not drawn to currency trading for the chance to lose money. You’re interested in making money, and you’re prepared to take some risks to do that. The question is how much risk are you prepared to accept. Because you’re dealing with finite resources in your trading — the amount of risk capital you’ve devoted to your trading — you have a definite limiting factor to your trading. If you eat through your trading capital, you’re done. So the starting point of a risk-aware trading plan has to focus on the downside risks.

That brings us to the trade setup, which we cover in greater detail in Chapter 12. A trade setup is a trade opportunity that you’ve identified through either fundamental or technical analysis, or a combination of both.

In every trade setup, you need to identify the price point where the setup is invalidated — where the trade is wrong. For example, if you’re looking to sell a currency pair based on trend-line resistance above, price gains beyond the trend line would invalidate your rationale for wanting to be short. So the price level of the trend line is the line in the sand for the overall strategy.

Now comes the entry point for the trade. Let’s say that current market prices are 50 pips below the trend-line resistance you’ve identified. That means the market could move higher by 50 pips and your trade setup would still be valid, but you’d be out of the money by 50 pips. You now have a clear delineation of how much risk your trade setup would require you to assume. If you get in now, you’re risking at least 50 pips.

Alternatively, you could reduce that risk by waiting and using an order to try selling at better levels — say, 25 pips higher. If the market cooperates and your limit-entry order is filled, you’re now risking only 25 pips before your trade setup is negated.

So how large a position should you commit to the trade? From a risk standpoint, it all depends where you’re able to enter the trade relative to your stop-out level (see the following section).

Doing the math to put the risk in cash terms

After you’ve identified where your stop-loss point is — where the trade setup is negated — and where you’re able to enter, you’re able to calculate the amount of risk posed by the trade. Let’s say you’re inclined to enter the position at current market levels, and your stop is 50 pips away. For example, if you’re trading a standard-size account (100,000 lot size), and the trade is in NZD/USD (where profit and loss accrues in USD), each lot would translate into risking $500 (100,000 × 0.0050 NZD/USD pips = $500).

If your margin balance is $10,000, you’re risking 5 percent of your trading capital per lot in this trade, which is frequently cited as the maximum risk in any one trade.

There are no hard and fast rules as to how much you should risk in any single trade, but we recommend limiting your risk to no more than 10 percent of your account balance.

If you’re able to enter the position at a better level (say, using the order to sell 25 pips higher), you’re now risking only 25 pips on the trade. You could double the position size and still be risking the same amount of trading capital. Or you could stick with the single lot and cut your risk in half.

Devising the trading plan in terms of risk

Risk in the trading plan is not confined simply to losing money on the trade. There are also opportunity risks from trade setups that you’re not able to enter. Another old market saying is that some of the best trades are the hardest to get into. You may be eyeing a trade setup that involves buying a dip toward rumored buying orders or significant technical support. But what happens if the dip never comes?

Identifying the trade entry points

Winning or losing on a trade is difficult if you never get into the position in the first place, which makes identifying where to get into the trade one of the most important steps in any trading plan.

We like to use technical analysis as the primary means of identifying entry levels. When looking to identify entry points, we focus on the following technical levels:

• Trend lines in various time frames (daily, four-hour, and hourly)
• Hourly highs and lows for short-term intraday position entries
• Daily highs and lows for medium- to longer-term positions
• Congestion zones
• Fibonacci retracements of prior price movements (38.2 percent, 50 percent, 61.8 percent, and 76.4 percent)
• Spike highs and lows

After you’ve identified a price point to enter into the trade, double-check the level. Is the entry level realistic? If you’re looking to enter a short-term trade, is your entry point likely to be reached in the short-term time frame (minutes to hours)? You can use momentum readings to help gauge the likelihood of an order level being reached. For example, if hourly momentum readings are moving lower, a buy entry to the downside probably stands a better chance of being reached than a sell entry above.

What happens if your entry level is never reached? Do you have a backup plan? If you were planning on selling on further rallies, for example, but the market moves directly lower, is there a price level below that you would consider selling at on a stop-entry basis? What does that backup plan mean for your overall trade stop level? Should you reduce the position size to compensate for the worse entry rate?

Establishing stop losses with foresight

The stop-loss level is the starting point in any trade plan from an overall risk perspective. It’s the point where the trade setup is negated and the strategy fails.

When considering where to place the stop level, be aware that the currency market, like most financial markets, has a tendency to try to take out levels where stop losses are likely to be located. Nothing is worse than having the right strategy but being taken out by a short-term, stop-loss-driven price move that eventually reverses and goes in the direction of your outlook.

To guard against the risk of being unnecessarily whipsawed out of a position, you need to approach selecting your stop-loss level from a defensive point of view. Anticipate that the market will test the level where the trade setup is invalidated, such as trend-line support or hourly lows. Then consider if the market tests that level, how far must it go through before it’s really considered a break.

No set formula exists for this calculation, but allowing for a margin of error can sometimes prevent a stop loss from being triggered unnecessarily. The margin of error you apply will depend on the general volatility of the currency pair you’re trading, as well as on the overall market volatility at the time of the trade.

Above all, you need to balance the risk of being taken out on a false move with the larger risk that your overall strategy is wrong. You can be flexible up to a point, but you still need to set your ultimate stop loss and then stick to it.

Setting take-profit objectives dynamically

When it comes to establishing the take-profit objective, a lot of trading books recommend using some sort of risk/reward ratio, like 2:1 (meaning, if you’re prepared to risk 50 points on a trade, you should be aiming to make 100 points). That approach is all well and good in theory, but it fails to account for the realities of the market. Just because you’ve identified a trade opportunity that risks x amount, why would the market necessarily “reward” you with twice that amount in profit?

Instead, we suggest using a much more dynamic market-based approach, one that considers where the market is likely to go based on where it’s been (technical analysis) and overall market conditions. The idea is to be realistic about how much you can take out of the market, not idealistic about how much the market will reward you.

We focus on technical support and resistance levels as the primary guideposts in the progress of market movements. If you’re looking to buy based on a Fibonacci retracement level as support, for example, you’re going to be looking at technical resistance levels above for your take-profit targets. Chart formations, such as channels and flags, also suggest relatively predictable and attainable price targets.

We look to momentum indicators like Moving Average Convergence/Divergence (MACD) and stochastics as gauges of the underlying speed of the price movement. If short-term momentum is accelerating in the direction of the trade, stay with it, and consider revising your take-profit objectives to capture a larger move. But if short-term momentum in the direction of the trade is slowing or stalling, consider scaling back your profit targets and adopting a more defensive, profit-protecting stance, like raising your stop loss or taking partial profit.

Time is another important consideration in dynamically managing your profit objectives. You need to be aware of and anticipate upcoming events and market conditions. If you’ve been long for a rally during the North American morning, what’s likely to happen when European markets begin to close up for the day? If you’re positioned in USD/JPY in the New York afternoon, and Japanese industrial production is slated to be released in a few hours, what can you expect in the interim? Stay flexible and dynamic, just like the market.

Choosing Your Trading Broker

With the explosion in online currency trading over the past several years, dozens of forex brokerage firms now operate all over the world. Competition among various brokerages is fierce, and there’s no shortage of advertising seeking to win you as a client. In this section, we look at some of the differences between forex brokerages from a risk perspective, because where you trade can sometimes influence your trading outcomes.

In case you skipped the introduction to this book, we think it’s important in the interest of full disclosure to note that we’re affiliated with FOREX.com. Before you choose a broker, we recommend you take a look at the Cheat Sheet, where we provide a list of questions to ask.

Different business models of brokers

Most online forex brokers function as the market-maker for your trading, meaning that the broker is on the other side of every trade — when you buy, you’re buying from the broker; when you sell, you’re selling to the broker. Brokerage firms that are market-makers typically provide both consistent liquidity and execution, which allows you to trade your desired amount at all times.

Market-makers typically offer either fixed spreads or variable spreads:

• Fixed spreads remain constant all the time, regardless of what’s happening in the market. Because the broker must assume the additional market risk of quoting a fixed spread all day long (including in thinly traded or volatile markets, when interbank spreads tend to widen), fixed spreads tend to be slightly wider than variable spreads.
• Variable spreads fluctuate depending on market interest. In highly liquid periods — such as the overlap between the London and New York sessions — variable spreads will be the tightest (as low as 1 or 2 pips in EUR/USD and the other heavily traded currency pairs). In slower periods (such as 6 p.m. Eastern time [ET], when New York is closed and Asia is not yet fully online), spreads will tend to be wider.

Whether you should choose fixed spreads or variable spreads largely depends on your trading style. If you’re a short-term trader looking to make just a few pips on each trade, you’re probably better off with variable spreads, which are tightest in liquid markets. If you trade around news, fixed spreads will allow you to avoid the inevitable widening of spreads (sometimes by a significant amount) that typically happens around fundamental announcements.

Another model being promoted by a few brokers is the nondealing desk model. The term is meant to differentiate these brokers from market-making brokers — who have trading, or dealing, desks — that manage the firm’s market exposure. Nondealing desk brokers will tell you that the price you’re trading on is coming directly from the interbank market and that they route all your trades directly to the banks. But if that’s the case, why is the nondealing desk broker even needed? Online forex brokers have emerged precisely because the large institutional players did not have the capacity to process tens of thousands of individual trades.

More important, if the nondealing desk is commission free and routing every trade to a bank, how does it make any money? A legitimate nondealing desk firm will offer very tight bid/offer spreads and charge commissions for each trade.

Commission-free forex brokers are compensated by the spread between the bid and the offer. If you buy from a broker at 15, for example, and another trader at the same time sells to the broker at 14, 13, or 12, the broker realizes a profit from the spread.

The reality with the nondealing-desk approach is that such trading platforms may display wider prices and sharper price gaps during periods of volatility, all the while claiming no control over the prices being shown. Be careful about promises of dealing in the interbank market — if it sounds too good to be true, it usually is.

Financial risks of brokers

The main financial risk posed by forex brokerages involves the brokerage firm’s failing due to mismanagement or fraud, as happened in the case of MF Global in 2011. If a brokerage collapses, your trading account could be frozen and your funds tied up in bankruptcy proceedings for months or lost forever.

To reduce that prospect, you need to make sure your broker is registered with the appropriate financial authorities in the jurisdiction where it operates. In the United States, forex brokers are required to be registered as a Futures Commission Merchant/Retail Foreign Exchange Dealer (FCM/RFED) with the Commodity Futures Trading Commission (CFTC) and are ultimately subject to CFTC rules and regulations. The National Futures Association (NFA) is the self-regulating body for forex brokers, similar to FINRA (formerly known as NASD, or the National Association of Securities Dealers), which oversees stock brokers regulated by the Securities and Exchange Commission (SEC).

You can visit the NFA’s website at www.nfa.futures.org to check on the regulatory status of a prospective broker. You should also review the brokerage firm’s regulatory history and its overall financial condition. Go with firms that have solid histories and strong financials.

Technology Issues and Contingency Planning

Online currency trading presents its own host of potential technological problems that you need to be prepared for. We cover the primary technology risks originating from the broker’s side in the previous section, but plenty of things can go wrong on your side of the connection.

Unfortunately, it’s the catch-22 of today’s technology: Without it, you couldn’t access the forex market in the first place — but when there’s a problem, it’s just another example of modern technology making your life more difficult. The trick is to anticipate what can happen and be prepared for when it does. We talk about the problems with technology in Chapter 4.

Contingency planning is the name of that game, and redundancy is the solution. By redundancy, we mean having a backup plan for your backup plan, with a backup plan in case the other backup plan fails. Now try saying that three times fast.

In particular, if your Internet connection is disrupted, make sure you’re able to call your brokerage’s trading desk; memorize its phone number and any account numbers or passwords you need to verify your identity, in case you need to trade or place orders over the phone.

Above all, make sure to do the following:

• Always have a stop-loss order in place for any open positions. This is your first and ultimate backup plan for any and all contingencies. Also, make sure your stop-loss order is good until canceled, so it’ll never expire while the position is open.
• Write down your open positions and orders. Keep a hard copy of all your trades and orders in a notebook or trading journal so you can refer to it in the event of an emergency. If you can’t access your brokerage’s trading platform, you won’t be able to see your exposure.