Lower Your Risks When Trading Forex
11/20/2012 7:00 am EST
The key to successful trading is less about winning than it is about minimizing your losses so you can maximize your winners and that takes discipline, observes Stuart McPhee of OANDA.
Gregg Early: I am here with Stuart McPhee, veteran currency trader and author of several trading books including Trading in a Nutshell, which is now in its fourth edition.
Stuart, with the dynamics of the currency market today, you have the euro, which nobody knows the direction of at this point-they can't figure out whether Greece or Italy's going to fall apart, and nobody knows what to do with it. The United States has flooded its system with liquidity. Japan doesn't seem to know what to do with the yen, nor does the rest of the world. How do you manage risk in this type of environment when you're trading?
Stuart McPhee: You bring up a very good point. I think regardless of market conditions, some of the rules remain the same. Some of the principles we need to follow are timeless and should always be adhered to.
The standard things like setting stop losses and sticking to them are things that should always be followed through, regardless of market conditions, regardless of the broader influences on the market. So, if we are in positions-which will happen regularly-that don't move in our direction, our favor, we're in a position where we can take care of those...just close the trade and move on to the next one. Some of those things really do remain quite timeless.
One of the other things related to risk can be volatility, and you mentioned things going flat and so forth. Of course, the opposite can occur when markets go wild and react very quickly to news, and announcements, and the like.
Again, we need to have some steps where we measure volatility, and ask when it is too much for our tolerance to risk and our personal threshold. Then it's really an option to hold back, not trade as much, maybe withhold from trading, maybe trade smaller sizes. There are certainly steps we can take when risk is increased and volatility increases; we can take steps to mitigate that and just reduce our exposure a little bit.
Gregg Early: So, really, fundamentally it's that basic rule of remaining disciplined-setting up your trades so if they head south, you make sure that you're out of them; that you don't hang on, hoping for the best.
Stuart McPhee: Absolutely. And what I'm saying now is not very new to many people; people have heard this before, you've heard this before.
But what are you doing about it? What steps are you taking to make this an easier process for yourself? Because if you don't do that, it's not very easy and you won't follow through like you said, about being disciplined and sticking to the plan. They won't do that if they don't make it easy for themselves.|pagebreak|
It's about putting little steps in place, having a plan, having a very clear-cut set of rules. Even things like a very common problem, setting stops too close to their entry price. There's a very natural tendency to do that, because we think we don't want to lose a lot of money. Therefore, we place stops very, very close.
But of course, by doing that we are significantly increasing our changes of being stopped out. And then we get frustrated when we're constantly stopped out that we decide not to follow through with our stops.
There are a lot of things we do early on in our trading lives, our trading journeys, that really don't make a lot of sense, but in the early days we don't know much better. It makes a lot of sense for us to do that then.
Gregg Early: Are there any hedging strategies that help when the markets become volatile, or is it all relative to the currency?
Stuart McPhee: You know, each currency has their own sort of, I guess the term is idiosyncrasies. You mentioned the yen earlier. It has its own very unique ways of moving. The BOJ is an influence there, and I know a lot of clients who don't want to trade the yen because of that influence.
Certainly, each currency does have its own unique little set of idiosyncrasies in the way they behave, and certainly key levels and price levels become very inherent to various currency peers.
Gregg Early: So, you're looking for the cleanest currencies to trade, even not necessarily the largest, either. So, it's more the predictability of the currency more than it is necessarily the size of the currency?
Stuart McPhee: Certainly, yes. I mean, there is certainly a natural attraction and draw to trading the major currencies, and we see that amongst our clients at OANDA.
We see that on our Web site when we display the sort of interest in each currency pair, and the euro/dollar is clearly head and shoulders above all of the others. More than a quarter of our clients' money is in the euro/dollar, followed by the Australian dollar, pound sterling, and the like.
So, certainly there is a natural attraction to some of those, and there are a number of reasons for that. There's more liquidity and tighter spreads and so forth.
You make a good point: people can gain a great feel and insight into the way a particular currency pair moves, and therefore they can get great comfort from monitoring it, and observing it, and watching it every single day. They actually get a great feel for the way it behaves when it does this...and when it does this, it often does this...and any trading strategy is designed to increase probability. What do we think is the most likely outcome from this point forward? Because then we can speculate on that by opening a trade.
Gregg Early: You're encouraging, within the context of trading, actually monitoring and getting to know these currencies almost intuitively, so you know what's going to happen the next time around, or the best probability for what's happening the next time around. Managing the risk is actually learning what you're trading and how it works in conjunction with the pair that you want to trade it with.
Stuart McPhee: Certainly, that is part of the risk management. But always, the underlying realization or reality is that anything can happen. Regardless of how good a feel or intuition we have, and we think the yen is going to do this, or the sterling will do this, the market will prove us wrong often enough.
We still need to clearly follow those rules and get out when the market does prove us wrong. You mentioned about the currency pairs-I mean, we offer over 90 currency pairs in metals, but very few people would trade beyond ten. You know, they would have their own little collection of maybe three or four, or five, eight maybe, that they monitor.
That's one of the attractions of foreign exchange over stocks. There are thousands of stocks on an exchange, and it's which one? Where do I start? How do I look for one? Here we have an environment where you may limit yourself to four or five currency pairs, so it certainly allows itself to become more intimately familiar with each currency pair and the way they move.