A Smarter Way to Trade

Hello traders! This newsletter comes to you from warm and sunny southern California, where I am just wrapping up a five-day forex class in Woodland Hills. As with most of my newsletters, this one is inspired by a couple of students and their questions/concerns.

These students are smart men, both having come from the technology industry. In their careers, (as with many smart people) they were bored and sometimes frustrated with their company’s procedures, policies and technology. Part of their jobs included improving what they could when they could. This desire to improve things applies to their trading as well.

As with many new traders, and traders who have been around awhile who aren’t as successful as they would like, they started to look for the “Holy Grail” in trading. However, the Holy Grail isn’t the perfect ENTRY, resulting in all winning trades! Most new traders believe this is the case, but the real Holy Grail in trading is proper risk management. All of the successful traders I know follow a few specific, even conservative, risk management rules. Some of these rules include:

  • Always use a stop loss, every trade, no exceptions!

  • Risk a small percentage of your account on every trade-often 2% is recommended. Too many traders will risk 20%-40% on a single trade! These folks won’t be around long…

  • No more than five positions (for example) on at a time. When new to trading, trying to manage several different positions can be difficult.

  • Because of the increased volatility around Fed interest rate announcements, some traders choose not to trade when the Fed makes interest rate decisions.

Now, there are many other rules that you could have in your trading plan but these are a good start.

So, let’s get to the real point of this newsletter. In my humble opinion, the way to make real money in the world of trading isn’t by spending hours trying to find the perfect entry, trying to be smarter than the market. After you follow the basic rules of risk management, I believe the real money comes from having great TRADE management rules.

What is trade management?

Trade management is making sure we have rules not just for entry AND exit, but also for while we are in the trade.  Obviously, the stop loss is there if prices go the wrong way from our entry, but what about when the trade goes in your favor? That’s the fun part! However, we need rules for that too.

One very simple rule I’ll throw at you is this: when trading 2 lots (for example) exit one lot when price has achieved a 3:1 reward to risk ratio. With the second lot, don’t have a fixed target, but manage this trade using a “manual trailing stop.” Without a fixed target, this trade could potentially run for hours, days, or even weeks!

What’s the Difference Between a Mechanical and Manual Trailing Stop?

Let’s define the manual trailing stop. Before that, I’ll define the “mechanical trailing stop.” Some traders like to use a stop loss that follows the trading price by a certain number of pips, or even a percentage of the price. This is convenient because you don’t have to be near your computer to have the trading platform move your stop along the way. Hurray, convenience! The bad part about the mechanical trailing stop is that the computer moves your stops into locations that a trader who was watching the charts never would. One quick move may move a 20-pip trailing stop (for example) in your direction, but a normal pullback might take you out of the trade when the trend is still valid. This might cause you to leave a lot of money on the table.

A manual trailing stop, or manual technical stop, takes advantage of the markets normal “waves” to help lock in profits along the way. It’s easier to describe with a chart:

EURUSD

In this EURUSD 120- minute chart, the trader could have gone short 2 lots at the supply zone marked, with a 20 pip stop loss (stop 5 pips above the supply zone.) A profit target of at least a 3:1, near an opposing demand zone could have been placed (marked here as the gold line.) As price approaches the profit target, the stop loss should be moved to past break even just in case things change direction-giving you a “free trade.”  (This location is not marked for clarity sake.) After the first target is achieved, it is now time to……wait!

Wait for what? Well, in a downtrend you are waiting for the downtrend to continue so you can move your stop loss. When the swing low, marked with the bright green line “A” is broken, you move your stop loss to ABOVE the high between what was the low and the candle that broke the low. Your stop is now at the red line marked “X”. And now you wait. When the swing low marked with the green line labeled “B” breaks, you move your stop down to the swing high between the low and the candle that broke it-marked with red line “Y”. Wait some more. Isn’t trading fun?

When the swing low marked with green line “C” finally breaks, your stop will be moved down to just above the high point between the swing low and the candle that broke the low, marked with red line “Z”.

In this example, with just a little more effort from manually moving your stop loss and following price, the original 3:1 reward to risk ratio would have expanded to over a 6:1 on the second half of your trade! Not too bad, I must say.

My recommendation to all traders, including the really smart ones who are trying to outfox the market, is to get better at managing your winning trades. Using this simple trend following rule should help your “realized” reward to risk ratios get much better than the original “planned” ratios!

This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results.