Forex Walkthrough

AAA

Trading Rules - Risk Can Be Predetermined; Reward Is Unpredictable

by Boris Schlossberg and Kathy Lien

If there is one inviolable rule in trading, it must be "stick to your stops". Before entering every trade, you must know your pain threshold. This is the best way to make sure that your losses are controlled and that you do not become too emotional with your trading.

Trading is hard; there are more unsuccessful traders than there are successful ones. But more often than not, traders fail not because their ideas are wrong, but because they became too emotional in the process. This failure stems from the fact that they closed out their trades too early, or they let their losses run too extensively. Risk MUST be predetermined. The most rational time to consider risk is before you place the trade - when your mind is unclouded and your decisions are unbiased by price action. On the other hand, if you have a trade on, you want to stick it out until it becomes a winner, but unfortunately that does not always happen. You need to figure out what the worst-case scenario is for the trade, and place your stop based on a monetary or technical level. Once again, we stress that risk MUST be predetermined before you enter into the trade and you MUST stick to its parameters. Do not let your emotions force you to change your stop prematurely. (To learn more on why you need a plan, see The Importance Of A Profit/Loss Plan.)

The Risk
Every trade, no matter how certain you are of its outcome, is simply an educated guess. Nothing is certain in trading. There are too many external factors that can shift the movement in a currency. Sometimes fundamentals can shift the trading environment, and other times you simply have unaccountable factors, such as option barriers, the daily exchange rate fixing, central bank buying etc. Make sure you are prepared for these uncertainties by setting your stop early on.

The Reward
Reward, on the other hand, is unknown. When a currency moves, the move can be huge or small. Money management becomes extremely important in this case. Referencing our rule of "never let a winner turn into a loser", we advocate trading multiple lots. This can be done on a more manageable basis using mini-accounts. This way, you can lock in gains on the first lot and move your stop to breakeven on the second lot - making sure that you are only playing with the house's money - and ride the rest of the move using the second lot.

Make the Trend Your Friend
The FX market is a trending market. Trends can last for days, weeks or even months. This is a primary reason why most black boxes in the FX market focus exclusively on trends. They believe that any trend moves they catch can offset any whipsaw losses made in range-trading markets. Although we believe that range trading can also yield good profits, we recognize the reason why most large money is focused on looking for trends. Therefore, if we are in a range-bound market, we bank our gain using the first lot and get stopped out at breakeven on the second, still yielding profits. However, if a trend does emerge, we keep holding the second lot into what could potentially become a big winner. (To learn more, check out Trading Trend Or Range?.)

Half of trading is about strategy, the other half is undoubtedly about money management. Even if you have losing trades, you need to understand them and learn from your mistakes. No strategy is foolproof and works 100% of the time. However, if the failure is in line with a strategy that has worked more often than it has failed for you in the past, then accept that loss and move on. The key is to make your overall trading approach meaningful but to make any individual trade meaningless. Once you have mastered this skill, your emotions should not get the best of you, regardless of whether you are trading $1,000 or $100,000. Remember: In trading, winning is frequently a question of luck, but losing is always a matter of skill.

No Excuses, Ever


Related Articles
  1. Forex Education

    6 Steps To A Rule-Based Forex Trading System

    Learn to add structure to your trading methods with these six important steps.
  2. Active Trading

    10 Steps To Building A Winning Trading Plan

    It's impossible to avoid disaster without trading rules - make sure you know how to devise them for yourself.
  3. Active Trading Fundamentals

    Beginner Trading Fundamentals: Limiting Risk

    Managing risk is the most important thing you do as a trader. Here we discuss probability and strategies for limiting trading risk.
  4. Forex Education

    9 Tricks Of The Successful Forex Trader

    These steps will make you a more disciplined, smarter and, ultimately, wealthier trader.
  5. Trading Strategies

    Patience Is A Trader's Virtue

    Waiting may be the biggest key to reeling in that trophy investment.
  6. Options & Futures

    Money Management Matters In Futures Trading

    Learn how this overlooked area of trading can help improve your gains.
  7. Active Trading Fundamentals

    Limiting Losses

    It is impossible to avoid them completely, but there is a systematic method you can use to control them.
  8. Professionals

    Surviving Your First Year As A Trader

    These tips will reduce the learning curve for first-year traders.
  9. Options & Futures

    Forget The Stop, You've Got Options

    Using options instead of stop-loss orders adds finesse and control in limiting losses.
  10. Options & Futures

    Tailoring Your Investment Plan

    Start your own investing adventure with the help of some simple guidelines.
RELATED TERMS
  1. Emotional Neutrality

    The concept of removing greed, fear and other human emotions ...
  2. Profit Target

    A predetermined point at which an investor will exit a trade ...
  3. Protective Stop

    A strategy designed to protect existing gains or thwart further ...
  4. Opportunity Cost

    1. The cost of an alternative that must be forgone in order to ...
  5. Stop Hunting

    A strategy that attempts to force some market participants out ...
  6. Mechanical Investing

    Buying and selling stocks according to a screen based on predetermined ...
RELATED FAQS
  1. Why should I invest?

    One of the most compelling reasons for you to invest is the prospect of not having to work your entire life! Bottom line, ... Read Answer >>
  2. How can I improve my credit score?

    If you are looking to take out a loan or apply for a credit card, then it will be very important for you to have a good credit ... Read Answer >>
  3. What's the difference between a stop and a limit order?

    Different types of orders allow you to be more specific about how you'd like your broker to fulfill your trades. When you ... Read Answer >>
  4. Debt Counseling: 4 Signs You Need Help

    Stop stressing about debt and bills and avoiding phone calls from debt collectors. Get help from a debt and credit counselor ... Read Answer >>
  5. How do I retire?

    When considering how to plan for retirement, firstly think about the age at which you want to retire and the lifestyle you ... Read Answer >>
  6. How can you lose more money than you invest shorting a stock? If you have no money ...

    The simple answer to this question is that there is no limit to the amount of money you can lose in a short sale. This means ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center