Knowable Risk Management

Hello traders! This week’s newsletter comes to you from sunny southern California, where the weather is 75 degrees and I’m teaching a futures class. My sympathies to all of my east coast friends who are suffering through a terrible cold and snow snap! Wish you were here! On that note, this week we’ll discuss some things to avoid in your trading, much like avoiding disastrous weather is part of my plan…

Now, when we talk about avoiding risks in the market place, it really comes down to the knowable things that we can avoid. We can’t really avoid the unknowables, right? At least, we can’t avoid them on purpose-otherwise these would be knowables! So, what in the world are we really talking about?

Specifically, I’m talking about things on the economic calendar. Much like looking at a long-term weather forecast can help you plan your travel and trips, your economic calendar can help you plan your trades. Do you like snow and cold? Then Buffalo, New York in February and March are good annual travel plans. Do you prefer warmth and humidity? Then Miami, Florida in August would be great!  In the world of trading, I prefer to avoid extremely volatile times, especially when they are accompanied by thin/illiquid trading levels. The question is, when and where do these times happen?

Economic Forecast

Much like looking at the forecast before planning a last-minute trip, I’ll check an economic calendar or two as I prepare for the upcoming trading week. There are numerous economic calendars that exist, some are provided by your broker, others on forex specific sites and many others on news/trading sites. My personal favorite is found on forexfactory.com, though the reasons I like this one are too numerous and in-depth to cover here. For a quick recap of the more significant economic announcements coming out each week, check out Power Trading Radio host, Merlin Rothfeld’s Chart of the Week.

At the time of this writing (4:30 pm on Tuesday, March 6), the major news events coming out over the next couple of days include an interest rate decision by the Canadian central bank, an interest rate decision by the European central bank, an interest rate decision by the Japanese central bank, non-farm payrolls and the unemployment rate for the United States. That is a lot of potentially significant storms – uh, economic events – that could move and shake the currency markets over the next few days! So how are we going to protect ourselves from these knowables?

Whenever there is an interest rate decision for a currency by its central bank, my trading plan’s risk management rules state that I must be OUT of ANY currency pair that includes that currency. So, an hour or two BEFORE the Canadian central bank releases its rate decision, no Canadian dollar trades for me. The main reasons are as follows:

1. Usually there is little directional movement right before the decision is released

2. The liquidity dries up, the spread gets a bit wide right before the release

3. If I’m in a trade when the release happens my stop loss might not be filled exactly where I want, there may be some slippage

Since I can’t quantify my risk to the pip, I’m not interested in trading.

Weekend Market Movement

Another potential storm in our trading can happen over the weekend. Most weekends there isn’t a lot of movement from Friday’s close to Sunday’s open, a few pips of a gap here and there but nothing earth shattering. I said, MOST weekends. Personally, I want to be out of all forex trades before the weekend, that way I never worry about a potential storm or large gap going against me. Some traders prefer to stay in their trades over the weekend, that’s fine for them. However, if you do choose to hold trades over the weekends, there are some storms that you should consider avoiding.

On these economic calendars, there are certain groups of bankers and economists who get together and make big decisions and recommendations on economic stuff. Some of these groups include the IMF (International Monetary Fund), World Bank and the Group of 7, 8, etc. When they get together, oftentimes their announcements and recommendations that come out over the weekend can cause significant gaps. Another instance where I’m not interested in holding onto trades where I can’t quantify my risk accurately.

So how, specifically, can we add some of these knowable events to our trading plans?

First of all, don’t be in trades of an individual currency when it has very important news coming out! That being said, because economic events happen almost constantly so it will be difficult to be out of every position for every economic event. I pay the most attention to the large events like the previously stated interest rate decisions, unemployment rates, and GDP announcements.

You could also have a rule that states that you will exit all trades before the weekend close, therefore eliminating all gap risk every single weekend. Or, you could choose to hold over the weekends, accepting the gap risk but not holding when the mentioned groups have their meetings. Alternatively, you could hold over every weekend, hoping for the best. Let me know how that works out…

Until next time, hope you avoid the knowable storms!

Learn to Trade Now