What Makes a Trading Method Sound?

Forex Trading Techniques : What makes a trading methodology “good”?

Risk Management : I would like to continue the dialogue on ways to find the right trading strategy for Forex trading. Previously, I shared that for any Forex trading method to be considered, it must be a complete method (insert link to previous article).

Today, I want to add to that by talking about risk management. This is perhaps the area where 95% of Forex traders mess up and lose money. Handling risk is about reducing your losses AND about safeguarding trade capital by employing precise strategies to do each of these simultaneously.

What do I mean by that and why is it important?

First, most Forex traders make easy trading mistakes : they take too huge of a position and reveal themselves to major and steep losses if the markets move against them. Second, they fail to protect their ENTIRE account by allowing ONE trade to put their full account balance at risk.

Here’s a quick and perhaps extreme example:

Suppose a forex trader has a $10,000 account balance. The foreign exchange trader takes a five standard lot forex trade on the EUR/USD pair. The currency exchange trader now has at least $5,000 ‘margin’ at risk ( or 50% or more of the currency exchange trader ‘s account balance ).

For each one point this foreign exchange trade moves against the foreign exchange trader , the trader loses 1/2% of the total account balance. Find out more read this Forex Income Engine 2 Report. At first glance, that may not seem like a steep loss. However, should the Forex trade move a total of fifty pips against the Forex trader , and the trader afterwards exits the position, the foreign exchange trader ‘s total loss would be an Fantastic $2,500! ( 25% of the trader’s account balance ). This is poor risk management and it often leads to finish wipeouts of Forex trading accounts.

How did we work out that loss? One pip for the EUR/USD pair is the same as $10 ( on the standard lot trade ). A 50 pip loss equals a monetary loss of $500; and remember our example forex trader had traded 5 standard lots — for a whopping loss of $2,500!

Instead, any trading method should teach you very specific guidelines for incorporating money management and risk management into every forex trade you take. For details see my Forex Income Engine 2 Review.

Cash Management should involve the distribution of a foreign exchange account among the diverse trades a currency exchange trader takes. As an example, currency exchange traders should never trade their complete account on a single trade, and should infrequently have more than some open positions. By utilizing multiple positions, the forex trader distributes the risk among each of the forex trades they have taken.

Risk management should involve the maximum risk in any SINGLE Forex trade, and should limit the impact of a losing Forex trade on the trader’s account balance.

Here are two quick examples:

Money Management: A theoretical forex trader takes 4 separate one lot trades on four separate pairs. Assuming here that each of the pairs have a pip value of $10 on a standard lot, then the total amount of the account being margined across all four trades is about 40% (it may be higher depending upon the actual pairs traded. With proper stop loss management, however, in conjunction with risk management, it is UNLIKELY that the forex trader would incur a complete 40% loss.

Carrying forward to risk management: In each of the theoretical forex trades above, the forex trader risks no more than 2% of the trader’s total account balance on each forex trade. That suggests a maximum loss of $200 per foreign exchange pair traded if ALL FOUR trades are stopped out. Total loss in this example would be $800 — a much more recoverable eventuality than the $2500 in the 1st foreign exchange trade example.

Furthermore, Risk Management has the capacity to make loss recovery simpler. As an example, in the 1st case, where the Forex trader lost $2500, the trader would need a virtually 250% gain on their next trade to recover the lost value on the 1st trade.

In the second example the foreign exchange trader would need only an 8% gain.

A second part of Risk Management not generally debated in poor trading strategies is protecting gains. Though this starts as a dialogue on Exit Method rules, it’s also a factor of risk management. Once a foreign exchange trade turns profitable, it is urgent the foreign exchange trader manage the gains with smart stop loss management. The worst thing a foreign exchange trader can do is permit a lucrative position to reverse and become a losing position. Thus, managing risk extends to the protection of gains on a forex trade, just as it does protecting against deep losses on a forex trade.

Therefore, in considering any trading method for use in your Forex trading, you must ensure that risk management is not only discussed, but clearly explained in conjunction with the use of the trading method. If risk management isn’t present, misleading, or not express to the trading methodology, you’ve got to avoid using that trading method. Find out more see my Forex Income Engine 2.0.