posted on 13 November 2015
by Rick Wright, Online Trading Academy
Hello traders! This week's article comes to you from beautiful Washington D.C., a few short days before Online Trading Academy's annual conference in Southern California. By the time you read this, the entire OTA family will be meeting or have had just met to discuss the upcoming year for OTA. Exciting things are always announced, so I am looking forward to the big meeting! Enough about that, let's talk about trading!
So the topic of this week's newsletter will focus on one of the most important topics in trading, yet one of the most overlooked by new traders. This topic is risk management. I can see some of you long time readers rolling your eyes, just bear with me! This old, boring topic is one of the most, if not THE most, important issue in trading. Too many new traders spend a huge portion of their time looking for that perfect setup or set of indicators that will make money on every trade, trying to get rich quick! If you have been trading for more than a few months, I know you've spent time searching for that Holy Grail! Most of the new traders that I meet ask what my favorite indicator is, a moving average, Bollinger Bands, Stochastics, etc. etc. My response to their question is "good risk management." So let's go through some recommended rules to help with risk management.
One of the first rules we teach is your reward to risk ratio. This is where you are willing to give up or lose a bit of money, looking to make a bit of money. Many traders start with a three to one reward to risk, where if I risk $100 my trade must have the potential to make $300. Pretty easy, right? Actually, that rule is almost too simplistic for real trading.
One interesting thing about this ratio is the difference between what our PLANNED reward to risk was vs. what the REALIZED reward to risk ended up being. When trading, you will find that when trading WITH the trend your realized reward to risk ratios will often be better than your planned ratios; when trading AGAINST the trend, very often your realized reward to risk ratio will be worse than planned.
In this chart of the AUDUSD I inserted a 20 period simple moving average. One of the easiest rules to determine trend is to look at what direction your moving average is pointing. Pointing up, uptrend, look for long trades. Pointing down, downtrend, look for short trades. (Yes, there are more effective rules but we'll stick with the easy one for this discussion.) Using Online Trading Academy's core strategy, I will look to go long at pullbacks to demand and go short at rallies into supply. Very often new traders will show me their trading history, and many times I will see that they are trading against the dominant trend direction. They will tell me that they are trying to get a 3:1 or better reward to risk ratio but they keep getting stopped out before their profit target is reached. The more experienced readers will probably recognize this problem as most new traders seem to have this issue at least once in their lives! Here is a possible quick fix to add to your trading plan:
When trading against the trend I will go for a 2:1 reward to risk ratio and take all profits at target one.
When trading with the trend I will go for a 4:1 reward to risk ratio, taking half position off at target one and managing the rest of my position using a manual trailing stop (or whatever your preferred method to trail is.)
Another rule of risk management that I believe should be in your trading plan is limiting the number of trades you take in a specific day or week. There are a couple of ways to do this. For example, some day traders will limit themselves to only 3 trades per day. This rule helps them be more selective in their trades. If you are planning on looking at your charts for 5 hours today, and you only have 3 trades to take, you will probably be pretty selective on which trades you take! My preferred rule for limiting trading activity is to use a daily (or weekly) loss limit. A common daily limit range is 3-5% of your trading account. Using a LOSS limit instead of a trading limit allows the active trader to continue trading as long as he or she is profitable! Why limit yourself to 3 trades if you are having a great trading day? Why not trade 5 times, or even 25 times if you are making money and want to be that active? Having the percent loss limit might mean that after your first 2 trades you may be done for the day. Oh well, come back tomorrow and trade again. Without a loss limit, some new traders have slowly lost their entire account as they tried to keep trading, just to "get their money back."
Now let's add a couple of more rules to your trading plan.
In every Online Trading Academy class that I teach, be it the seven day core strategy class (Professional Trader course) or one of the five day classes (Professional Futures or Professional Forex courses) we discuss the merits of using quality supply and demand zones to place our trades. We use ours odds enhancers, which essentially show how the charts are "shaped" to help us decide what zones are good enough to risk our money on in a trade. Some of these odds enhancers have been discussed before, but here we will discuss how to add some of your own (customized) to different forex symbols.
One extra odds enhancer that some traders use is the correlation between the pair you are considering trading, and the relationship to the US Dollar index. In the stock market, a possible odds enhancer is to trade stocks that "line up" with the market index that they are represented by. When trading a technology stock, very often traders will also check the relationship of the Nasdaq market to see if they are both trading into a supply or demand zone at the same time. When both your stock and your index are in a demand zone, the odds of your trade working out are greater. I'm sure most of you have heard the phrase "a rising tide lifts all boats?" The same thought applies here. If the stock market starts rising, most stocks (at least the ones with a high correlation to the market!) should rise as well. When trading certain currency pairs, some traders will use the US Dollar Index as an odds enhancer to certain currency pairs.
As you can see in this pair of charts, the EURUSD currency pair has a near perfect inverse relationship to the US Dollar Index. The current "score" over the past five months is approximately -0.93. (Correlations are more fully described in my articles, currency pair correlations part 1 and part 2.)
In this chart, the blue circles represent a turning point where the EURUSD made a swing low, while at the same time the US dollar index made a swing high. The pink circles represent where the EURUSD made a swing high and the index made a swing low. This is an obvious inverse correlation. A possible odds enhancer or risk management rule could be that you will only trade the EURUSD on the short side in a quality supply zone when the US Dollar is simultaneously in a quality demand zone. On the opposite side, only trade the EURUSD from the long side at a quality demand zone when the US Dollar index is in a quality supply zone. As stated in the previous newsletters, please make sure the correlation between the currency pair in question and the US Dollar index is a strong one! Adding this rule to a pair that completely ignores the index will certainly not help your trading. Yes, you can also use certain commodities (gold, oil, etc.) and their correlations as well. Let's take another look.
In this AUDUSD and Gold futures chart, you can see that the charts themselves are somewhat correlated, at least to their turning points. I intentionally chose a pair of symbols that weren't lining up perfectly, just to demonstrate that not everything does! From the blue circles both symbols had a strong move to the downside, and in the pink circles they both had a strong move to the upside. However, looking closely you can see that the up moves did not start on the same day. In fact, the AUDUSD started a strong move up several days prior to gold's move. Remember our core strategy and how to use the correlations? When both symbols are in a quality demand zone (not marked), you can look to be a buyer. As both gold and the AUDUSD were in demand, the forex trader certainly could have gone long the AUDUSD.
So there you have it. Using the correlations as an odds enhancer to help manage risk in your trading plan can be a very useful tool. In my next newsletter, we will discuss even more ways to help limit and manage your trading risk.
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