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Techniques to improve your trading strategy
A lot has been written about money management in trading and a trader is likely to hear about the importance of money management – over and over again. Yes, money management is of importance when trading, but something that is not considered by many beginner traders is developing proper money management skills based on his/her own personality, expectations, the market s/he wishes to trade in, the available investment capital and a reliable trading strategy?
Most articles on money management only touch base on the importance of it i.e. stop loss placement, your risk/exposure in the market and risk/reward ratios. We believe that these considerations are not nearly enough if you want to make a success out of trading.
Before you even think about opening an account with a broker, in which ever market you are planning to trade in, it is of vital importance that you determine what personality traits you have and focus on developing a trading strategy that suits those traits.
Success means different things to different people. What is your meaning of success? Perhaps your measure of success is growing your investment capital over the long term, saving up for a holiday or becoming a full-time trader? Whatever it may be, it should be realistic and approached with the right trading plan.
In “Forex Trading: The Essential Beginners’ Guide” we covered the subject of creating a trading strategy around your personality and referred you to some essential reading material. Please be sure to review this material, if you have not done so already, before continuing with this guide. This document will assume that you have already developed, or are in the process of developing a strategy. Our aim here is to discuss proper money management based on a solid trading plan.
3. Taking what the market gives you
Whatever time frame you wish to trade in, whether it be day-trading, medium- or long-term trading, it is of the utmost importance that you take as much profit as you possibly can while it is available and the market is willing to give it to you. A decent trading strategy should base itself on first accepting the initial risk, i.e. setting a stop loss order; then setting a first target objective; moving off the stop loss order so that you break even after your first target has been filled; and THEN following the market and adjusting your stop loss along the way to ensure maximum profit . This all sounds very simple but your discipline will be stretched to the limit.
Many beginner traders will tell you that they are right about the direction of market more than 60% of the time when entering into a trade. Unfortunately, most of them end up losing on the trade because they can’t manage their open trades properly and end up turning a winning trade into a losing trade. This is mostly caused by greed, emotion, an improper trading management plan, lack of experience and ill-discipline.
4. Managing an open position
This article will discuss basic position management skills that should make up part of your trading strategy. Planning a trade and entering into a trade is a small part of the actual process of trading. Success in trading relies largely on the management of an open position. It is entirely possible to have a strategy with less than a 50% winning expectancy, and still make it successful. It is all about how you take profit and manage your risk.
4.1 Stop loss placement
There are many differing opinions about where exactly to put your stop loss orders. Some say that it should be a percentage of your equity, ranging between 1 – 4 percent. Some say that it should be above or below certain pivot points, resistance or support levels etc. They may all be right, they may all be wrong. I honestly believe that stop loss orders should be placed according to your risk profile. There are no set rules in stop loss placement. One trader’s idea of risk might be much different from another. A trader’s amount of capital available for trading can also be a factor. It can even dictate as to which type of market you want to trade in i.e. Forex, CFDs’, Futures etc.
One thing is for sure though: No position should be taken in the market without the protection of a stop loss! Where you place it will become clear when you have finished developing and testing your trading strategy. Stop losses are there to protect your equity and, very importantly, to provide you with the peace of mind that you cannot lose more than the risk you were willing to incur on any given trade. It should therefore reduce the amount of emotional stress associated with entering into a trade. It would be impossible for me to say where exactly to place your stop losses. What works for one trader might not work for another. That’s why it’s so important to develop your strategy around your own personality. I cannot stress this point enough! What I can do is provide you with some tips when considering stop losses. They are good points to consider when developing strategies and could reduce your chances of having your stop loss orders filled.
4.1.1. Order congestion areas
Try to imagine where most waiting orders are in the market. Remember that price value in any market only fluctuates because of one thing: to fill orders. The market price always gravitate towards were the most orders lie. You therefore need to be careful to place your stop loss orders where many other orders might be “bundled” up. Success in trading often relies on you doing things differently than the mainstream. Note that I am referring to stop loss placement here only! For instance, it would just be silly to try and do things differently in the case of a strong trend by going against it.
4.1.2. Important levels
This ties in with the above point: Determine where important levels may be, like Fibonacci retracements, pivot points, support and resistance levels. Orders tend to bundle up there so try to place it further away from these levels.
4.1.3. Market manipulation
Many markets can and will be subject to market manipulation from time to time. This occurs when large institutional traders swing the market, at least temporarily, to have their orders filled at better levels. This is also referred to as stop running. For example: Let’s say the market price was moving downwards. All of a sudden the market reverses and moves the opposite direction for no apparent reason. What is happening is that the large traders were able to place very large buy orders close to, and above, the current market price in order to draw the market upwards towards levels where they know the majority of traders have their stop loss orders, i.e. where buy stop orders are bundled.
Once the market reaches these levels (where most stop loss orders lie), in this case buy stop orders, it will accelerate upwards because of the buy orders. This can go on until many areas of buy stop orders are filled and the stop losses are almost depleted before the big players again sell into the market gaining a much more favourable position. Then, as before the trend, the market continues in its previous direction downwards.
How did they fill their large sell orders? By using your buy stop orders! Remember, there has always got to be an opposite side of an order to have it filled. Luckily this tends to be only temporary, as even the large traders do not have enough buying/selling power to do this on a permanent basis. This practise mostly occurs around market opening times and major news releases. So keep an eye out for them and factor the possibility of “stop running” into your stop loss placement.
4.1.4. Allow the market some space
There is nothing more annoying than seeing your stop loss orders filled and the market returning in your intended direction. Like mentioned above, it can be caused by many factors but many traders also make the mistake of setting their stop loss orders too close to their entry orders. They do not allow the market enough space to run its course. How far away you set your stop loss order will again depend on the time-frame you trade in, i.e. a long-term trader will have his/her stop loss further away from entry than a short-term trader would. Your stop loss placement could therefore rely largely on the amount of equity available for trading, your risk tolerance etc.
4.2 Profit objectives
Since trading should be approached and managed as a business, it is recommended that a decent trading strategy include at least one target objective or stop loss adjustment (read point 4.2.1) that will cover your immediate trading costs, i.e. brokers’ commissions, internet connectivity costs etc.
4.2.1. Overhead cost covering
When trading any market the participant should be aware of all fees associated with trading. Depending on how involved you are with trading i.e. day-trading, long-term trading or trading for a living, each one of these styles will inevitably incur fees. For example: A day-trading strategy may rely on opening and closing many positions throughout the day, therefore incurring higher costs than let’s say a long-term trader that would open one position and keep it for a longer period of time.
Know what it costs to trade and work that costs into your trading strategy as a loss. It is therefore a good idea to either factor in the costs as part of your total risk and include it in your stop loss placement or have a price level not too far from your entry price that will cover these costs by buying or selling back a percentage/portion of your open position.
4.2.2. Banking profits
Another good idea to use in your trading strategy is to bank some money while it is available. This could be an equal distance away from your entry as your stop loss is. Here it would be wise to do two things:
1. Buy/sell a percentage or portion of your position and keep the remainder in the market for further profit potential.
2. Once you completed point 1., move your stop loss to break even, i.e. your entry price so that you cannot lose on the trade anymore.
A combination of the two methods works well because it eliminates the risk of turning a winning trade into a losing trade, and it also creates a healthy habit of taking money while it is available. This way you will, most of the time, have something to show for your efforts. Managing the remainder of the open position will be discussed in the next point.
4.2.3. Trailing the market
The amount of profit-taking at your first profit objective is up to you, and this should be tested in conjunction with your strategy development. Some traders prefer to keep 50% open and some prefer to keep 20% open, this will depend on your strategy. Sometimes it is possible to make more money by tracking the market with a 20% open position than a 50% open position. Playing around with that percentage will make sense when you analyse historical price movement based on your strategy.
Trailing the market in your intended direction is achieved by adjusting your stop loss order up or down in the direction of your intended trade. By doing this you ensure that even though your stop loss is hit, you are still making a profit and this is the best way to ‘milk’ the market of as much profit as it is willing to give. But where is a good place to place your trailing stop loss order?
Below are a few suggestions:
1. By using an automatic trailing stop. This is a feature that most broker platforms include. It works by entering a value that is a set distance away from the current market price. Let’s use an example: You have banked your first profit objective and have 20% of your position active in the market. Your intended direction is up. Your original entry was therefore a long/buy position. You decide to use the automatic trailing stop feature and enter a value of 30 points. So if the market, for instance, continues upwards the trailing stop will automatically trail the market price in the same direction 30 points behind. However, if the market moves down, the trailing stop will not move down with it, ensuring that you gain maximum profit out of the move.
2. Support- or resistance levels. This is a manual method involving the trader moving the stop loss order his/herself and placing the stop loss order above resistance levels or below support levels.
3. Indicators. There are many indicators on the market, but one way to use them as a guide to placing your stop loss order is to use a moving average line suited for your time-frame. This requires some research as to which settings to use, but is well worth the effort. Please note that in this case, the line may be used as an indication as to where to place your stop loss and not as an entry or exit signal in itself. They work well in trending markets as prices tend to ‘bounce’ of them when markets are making corrections. Therefore it makes sense to place your trailing stop manually at a set distance below/above these moving average lines. Again this will have to be back-tested when developing your strategy!
4. Chart patterns. In our previous guides we recommended the study of price patterns. Stop loss placement can be very effective when using these patterns. For instance, in the case of a strong trend, look out for these price patterns and place your stop loss below/above them. This is a good technique as it is highly accurate because you are adjusting your stop loss according to what the market is ‘telling’ you rather than what you think it is going to do.
Exiting the market by any of the above means will ensure that you gain maximum profit out of a trade. In my experience, it has to be noted that this way of profit-taking opportunities only rarely occur in any single market, taking into consideration that the market only trends 20% of the time and spends up to 80% of its time in sideways movement or congestion. Unless you have a strategy that can trade in congestion periods i.e. smaller time-frames, or trading smaller trends within congestion, then you probably have to be more patient and wait for the correct setups. These tend to be trades with higher probability of winning and, when they do come along, they can offer very good profit indeed. It is therefore of the utmost importance that you manage your open positions when they eventually do come along!
4.3 Further risk reduction
It often takes patience to find the right trades to enter into. But finding markets that show the correct setups for entering high probability trades does not have to take forever. With our recommended broker you will have many markets to choose from, bringing opportunities to trade more often than you might think. Just be sure to understand the market you want to trade in, the risks involved, and how it tends to behave under certain conditions.
Another way of reducing your risk even further in any given position is to use the concept of time limits. Before I explain this concept further, just take note that this practise can be achieved by making it a rule in your trading strategy or by plain instinct. The latter comes with experience and the aforementioned should be tested using historical price action when you develop your strategy.
4.3.1. Time limits
Using a time limit to reduce your risk is easy. It simply entails rather exiting an open position if it does not go in your intended direction after a certain time, and accept a smaller loss than your stop loss being triggered. Time limits are mostly used with strategies that rely on momentum breakouts. If price movement fails to move properly in the intended direction, then chances are that it might have been a false breakout, bringing your stop loss into danger. The concept accepts smaller losses and allows the trader to move on to the next – hopefully big – move.
A word of caution here, this has to be tested on your time-frame of choice in conjunction with your trading strategy. Stop losses are there not only to protect your equity but also to allow the market some space. Test the use of a time limit on your strategy and see if it works. They are certainly used by top traders, but in their case it has mostly to do with a gut feeling that things are not what it seems, and so they cut their losses short and let their profits run. This comes with experience, and a gut feeling for a novice trader can be the wrong thing to learn when starting out. There are certainly times though, when it’s worth getting out of a trade and just move on.
4.4 Trading journal
A great part of proper money management is to keep a meticulous journal of every trade that you have taken. Even if the trades were demo trades. Get in the habit of noting everything there is to note about the trade, i.e. date, time-frame, strategy used, market you are trading, stop loss price, entry price, profit objective price, total commissions/costs, final exit price, profit or loss amount and even how you felt before the trade, after the trade and why you took the trade in the first place.
The use of a journal is threefold (assuming that you are honest with yourself):
1. Trading is a business and should be approached like one
2. A journal installs discipline, and
3. Provides a record of your trades, but more importantly, it could highlight why trades went wrong or signal that your strategy is faulty and need to change.
This guide about money management was written to show the aspiring beginner or intermediate trader possible ways of managing his/her open positions. It should have become clear that trading is not only about pushing a few buttons, but that success depends heavily on many factors, like a decent trading strategy and proper money management. Trading is not easy to start off with – if it were, more people would be doing it and be successful at it. Currently, less than 10% of people who start trading are successful at it. This is largely due to misinformation and improper money management.
If you want to make a success out of trading, then walk the road step by step. Read and follow all our guides and recommended reading material. As I have mentioned in a previous guide – the road to success will be quicker if you have been exposed to the right material from the start. It is my hope that this material will serve you in the right way and get you thinking about the important aspects of trading that the majority of people who lose their money have overlooked.
To your success!