Your Trading Plan
Many traders jump into capital markets such as Forex, CFD’s and stocks without a proper trading plan. Yes, they have a strategy and goals but a decent trading plan is not written nor is it considered.
Without a proper investment strategy you are completely exposed to psychological risks as we described in our Forex trading manual. The aim of the article is provide a constructive plan on which we would lay out the essential elements that should be included in any type of trading strategy in global markets.
This applies for trading in the Foreign Exchange market and CFD’s. We have seen many traders leveraging their investment by 100:1 and more, dazzled by the potential profit on the paper, unaware of the forthcoming losses. If we will take an investment of $50,000, applying 100:1 trading leverage means the value of each pip is $500 (approx.).
If the market is 100 pips against the executed trade (we are ignoring the margin call) the whole invested capital will be soaked up in the market. Even by placing a stop loss order of 30 pips mounts to a potential loss of $15,000, which is approximately 33% of the investment, a ridiculous market exposure.
Even if the investment’s exposure to the market was 20%, it is enough for the market to trade against you five times and your investment will be blown away to the hefty pockets of the market maker or to the market bulls and bears that enjoy the fine taste of your investment.
The hypnotic-like effect of the potential profit by over-leveraging the investment is so powerful that it blinds the eyes of many educated traders. One way of constructing an investment strategy is to predetermine the leverage you wish to exercise. Our suggestion is to use only 5:1 at any given time.
In such a scenario, if the investment is $50,000, 5:1 leverage is a trade of 250,000 (2.5 lots on the MT4). If the stop loss order was 30 pips, and it was taken out by the market, the incurred loss would be $750 (each pip is worth approximately $25 in a 250,000 trade). As the investment is $50,000 you have only exposed 1.5%. Likewise, ensure the total of the potential loss does not exceed 5%, in our example it would be $2,500.
This is a classic risk management technique to ensure that you will still remain in the market even after incurring consecutive losses, a privilege over-leveraged traders do not have.
The Financial Instruments
Diversity is an essential part of managing your trading portfolio. The classic proverb, “Don’t put all your eggs in one basket” also applies to online trading. At first glance, some of you mat interpret this as spreading your investment over multiple asset classes such as Forex, Commodities, Stocks and Indices but no necessarily. It simple words, you cannot overexpose your self to a single instrument.
Returning to our previous example of $50,000 investment. If have 250,000 available for trading (with a leverage of 5:1) I will not place them all in one trade. Some trades believe that by splitting the 250,000 into multiple trades, let’s say ten positions as an example then they have diversified their investment. Absolutely not. Diversification in the Forex market can also be interpreted as net currency exposure.
If you execute short trades in GBPUSD, EURUSD, AUDUSD and NZDUSD short, each trade worth 50,000, your net exposure to the US Dollar (USD) is extremely high. That means if the US Dollar will weaken you are likely to incur losses on all open trades. You must balance your net market exposure per currency to maintain a healthy risk management.
Predetermine the net exposure level per currency. If you are only trading Forex you may spread the exposure equally amongst the major currencies, EUR, USD, AUD and GBP, allocating 25% of the available 250,000 for trading for each currency. If you wish to add CFD’s to your trading portfolio, let’s say Commodities, you can spread the available capital equally or 60% for trading forex and 40% for trading commodities (for example). If you wish to add stocks the same applies.
The Stop Loss Orders
Now that we clarified the leverage setting your stop loss orders should be simple. Firstly, it is essential to highlight you cannot predetermine a fixed amount of pips for each stop loss order you place. Volatile currency pairs such as GBPAUD will often require a larger stop loss order than EURCHF.
If you do not know how to decide where to place your stop losses we suggest you read our “Stop Loss Trading Strategies.” What can be predetermined is incurred loss in real money by altering the trade size. For example, if I were to place a 30 pips stop in EURUSD with a trade size of 10,000 (0.1 lots in the MT4), than I know the loss would be $30.
If in a particular trade a 300 pips stop is required, which would be a $300 loss in a trade of 10,000, all that is needed to be done is to reduce the trade size. If the trade size is lowered to 3,000 the stop loss will be $90.
It is entirely up to you by how much to reduce the trade size until the value of the stop loss order in real money is satisfactory. Of course, the take profit will be affected but this is how over-leveraged traders look at the market. Understand that stop loss is some times more important than your garnered profit. Controlling your market exposure will lower the possibility of being knocked out the market in a relatively short period of time.
The Risk Ratio
The Risk Ratio (RR) is an important part in risk management. We are all aware it is impossible to succeed on every trade. By employing a decent RR a high success rate is not required in order to be profitable by the end of the month/quarter/year. The RR is calculated the pips differentials of you stop loss order and take profit.
If your stop loss is 20 pips while your take profit is 40 pips, your RR is 1 :2. Your take profit is twice as much as your stop loss. If the trade sizes are the same for all trades your will need just over 50% (due to the spread) in order to break-even while a success rate of 60% (approx.) will mean a decent profit.
A suggested risk ratio is considered to be 1:3 and above ( 1:4, 1:5 etc.). When your take profit is 3 times your stop loss, a 45% success rate will be sufficient in order to maintain a decent Return on Investment (ROI) by the end of the month.
The Risk Ratio combined diversifying your investment portfolio will make a strong risk management, minimizing the odds for substantial losses. The Risk Ratio must be determined by you before entering the market. This does not mean random stops and take profits will be made in order to meet RR of 1:3.
Remember that your take profits are also determined by technical analysis such as support and resistance levels and that you have very little say in the matter. If a potential trade does not meet your RR consider letting it go and focus on the your next trade.
Keeping a Track Record
When you finally begin trading you must write down every trade you place in the market. Write the date, the time, the financial instrument, the trade size, the time frame the trade is based on (15min chart, 1 hour chart, daily chart etc.) the entry price, stop loss, take profit and the reason for executing the trade.
Likewise, when the trade is closed, manually or the stop/take profit order were triggered, write down the date and time it and the accumulated profit in pips as well as real money. If you are realizing partials, write down the date, time, the market price and how much was liquidated.
If you are asking why is it all necessary the answer is simple. Monitoring your performance will allow you to improve your trading strategy in the market. It is essential you keep track of every trade and the reason behind it so you may study it at a future date and decide whether any modifications are required to your trading strategy.
If for example you notice you have very successful trades on the daily chart and a poor performance on a 30min chart you might want to consider not basing your trades on the 30min charts.
Writing it all down will serve you in the medium-term. We are aware some will find it as extra work but if it will only improve your success rate than why refuse? It is also essential to write down the amount of leverage you wish to use, how you wish to diversify your investment and your Risk Ratio.
When you wish to make any medications, instead of executing them in your mind, which is likely to be tired from the market psychological battles, writing down will be more efficient.
To conclude, all the above must be predetermined before trading the market. If you are already trading and unsatisfied with your trading performance perhaps taking the above suggested steps may substantially improve your risk management.
Taking these steps will shed more clarity on how you should trade the market, reducing if not eliminating irrational decision-making due to the lack of a proper investment strategy. You are welcome to view our market education section for more informative material on global markets.