Obvious Trading Tips Forex Traders Still Tend to Ignore

11/25/2009 12:03 am EST

Focus: FOREX

Kathy Lien

Managing Director and Co-Founder BKForex LLC, BK Asset Management

On this quiet trading day devoid of much market-moving US data, we take this opportunity to share some tips that we have to help you improve your forex trading. Regardless of whether you are learning to trade for the very first time or seasoned, we hope that you find these tips useful. Feel free to add your own tips in the comment section below!

Tip #1: Buy High and Sell Higher

Believe it when they say that the trend is really your friend. When you trade currencies, you are trading the outlook of a country, and typically, the economy of a country will get progressively better or progressive worse, and rarely will it be better one minute and worse the next. This is why trends are so dominant in the forex market. For example, take the performance of the Australian dollar against the US dollar. In 2008, the Australian dollar fell for five months straight against the greenback in a move that shaved more than 35% off of the value of the Aussie. However, almost as quickly as the Aussie sold off in 2008, in 2009, it appreciated by approximately the same amount over the course of nine months. Trends in currencies can last for weeks, months, and in some cases, even years. Therefore, by buying high and selling higher, or shorting low to buy back lower, you put yourself on the side of the trend, which should help to improve your trading. People who fight the tape, on the other hand, could be extremely frustrated if they try to do this with currencies.

Tip # 2: Entries and Exits are Equally Important
 
Ask a pilot what is more important, the takeoff or the landing, and ask a surgeon whether it is more important to get the first incision or the sutures right, and they will most likely tell you that both are equally important. Traders should have the same mentality when it comes to entries and exits. Unfortunately, most new and even seasoned traders spend hours looking for trading strategies that give them the best possible entries. Exits, however, are usually relegated to nothing more than an afterthought. This type of behavior is one of the single biggest reasons why many people have difficulty making money from trading. In fact, I am sure that everyone reading this article had the experience of watching their trades move favorably initially, only to reverse violently and be stopped out. This is the central reason why exits are just as important as entries, especially when you are trying to capture a big move. This is why it may be fruitful to employ the use of trailing stops, because if you are aiming for a 5% move, the worst thing that could happen is for the trade to move 4% in your favor and then turn around. By using trailing stops, you can lock in profits along the way, which is essential to maintaining a positive edge.

Tip # 3: Look Beyond 2:1 Risk-Reward Ratios
 
Trading or investing 101 states that in order to profit in the long run, you have to maintain a 2 to 1 reward-to-risk ratio. This means that for every $1 that you risk, you should look to make at least $2. Unfortunately, in the forex market, this may be difficult to achieve, particularly for short-term traders. Let us consider a short trader who is looking to make 20 pips on a trade. If he was to maintain 2:1 risk-reward ratio, his stop would need to be ten pips. However, ten pips is just little bit more than the spread for many currency pairs, which means that the risk of being stopped out is very high. Alternatively, if a trader knows that support is 50 pips away from the current price, then to maintain a 2:1 ratio, he would need to have a take profit of 100 pips. Given that 100 pips is typically the average high-to-low range of a currency pair, it may be difficult to make 100% of an intraday move on a short-term trade. A 1:1 risk-reward ratio can also work as long as the strategy has an accuracy rate of 65% or greater, which tends to be a bit more suitable for short trading. For example, if you putting on a momentum trade after an economic release, your target and your stop may only be 20 pips because you are looking for immediate continuation. However, in order for this to yield net positive results, you would need to make sure that you are right much more often than you are wrong.

Tip # 4: Technicals and Fundamentals Both Matter

Many currency traders focus primary on chart reading because it is simple and straightforward and they believe that everything is factored into the price. This may be true to some extent, and while I believe that technical analysis is useful, particularly on a short basis, trading solely on charts is akin to walking around with blinders on. Fundamentals not only determine the current trend in exchange rates, but for any major technical trend to change, fundamentals need to change as well. On a more granular level, day-to-day economic data can also alter the short-term trend in a currency pair or trigger a breakout. So it is extremely important for people employing technical analysis to be aware of economic data that will be released so that you can properly assess the risks to your trade.

Tip # 5: Do Your Homework

Finally, it is important to do your due diligence, not only in terms of the trading strategies that you learn, but also in terms of the brokers that you choose to trade with. One of the biggest benefits of the foreign exchange market is the ability to test drive strategies on virtual demo accounts. Make sure you can make money on the strategies while trading on a demo or a small-sized account before diving in head first. In terms of brokers, make sure that you test out a number of brokers before you commit to one of them so that you can compare their services and pricing to see who really has the highest integrity.

By Kathy Lien of GFTForex.com

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