eSignal - Smarter Trading Tools

Risk, Can You Handle It?

September 3rd, 2014

AnneChapman_TheDynamicTrader By Anne Chapman, TheDynamicTrader.com

Risk is a word often batted about when talking about trading. Not without good cause, I might add. But the true risk often lies in the less obvious.

Risk is usually mentioned in the context of stops and cutting your losses short. This is sound advice. It’s difficult to accept that all your analysis has led to a dud trade. So having an automatic stop loss in place takes the emotion of the decision making out of your hands.

Unfortunately, inexperienced traders frequently interpret this as having close stops (maybe just 10 or 20 pips/points). This creates a need for price to very quickly go in the traders favor. In truth this rarely happens making this is a high-risk strategy.

tight stops = higher risk

There are many frustrations with small stops. One is that there will be an awful lot of losing trades. Losing trades are part and parcel of trading but such tight stops will quickly outweigh any profits. This is because the winning trades won’t harvest enough pips/points to cover the losers (as they, too, have small stops).

A second frustration is that soon after getting stopped out the market will often reverse and continue in the original direction. In reality, price rarely moves up or down in a straight line. Buyer and sellers, by definition, make sure there’s an ebb and flow to the markets.

The good news is that this issue is one that can easily be mitigated.

DT Tip: Experience in trading is all about mitigating small annoyances. Finding solutions to increase the probability of a trades success is what separates the wheat from the chaff. The quicker you can do this then the quicker you will turn a profit (or turn a small profit into a larger one).

If you are risking 1% of your account on a trade you can use smaller denominated per pip/point and increase the distance of the stop. This will give the position a change to ‘breathe’ so timing does not become as much of an issue. (Don’t forget to keep the trailing stop a similar distance away so you can ride the trend). So choose 10 cents a pip/point rather than $1, for example.

fewer lots = lower risk

Using fewer lots (smaller monetary amounts per pip/point) clearly means that as price heads in your direction you don’t get as much profit for the same move. In theory this means we won’t make as much profit, right? Wrong! Let’s look at the next aspect of risk.

Every time you enter a brand new trade your risk is greater than adding to a position you already have in play. This is a rule that’s been used in business since time began – it’s far more cost effective to sell to a current customer than to go out and find a new one.

new trade = higher risk

With each new trade you take the risk is high (regardless of how good your analysis is). Failure is more likely than success (see my post “To Win You Must Lose”). But if you already have a successful trade in play you can add to your position with little or no risk.

Adding to a current position means that as the trend develops you can quite quickly, and safely, build up your lots to a good monetary value per pip/point. A trend in play offers lower risk than a possible new trend in the early stages of development. The water’s been tested and I like it!

Another high risk strategy often used by new traders is to go for low liquidity markets. Pink sheets (or penny shares) are often seen as a quick road to riches. They can move 500% in a few hours or even in a few minutes. The difficulty comes when you try to offload them. With low volume comes low liquidity. You are likely to find you cannot close your position at anywhere near to the listed price. You have become the market as you are the only player.

high liquidity = lower risk

It may not be as exciting to trade the S&P500 or the major Forex currency pairs, but they are popular for a reason – you can get in and out at (or close to) the price you want.

Markets with high volume (liquidity) are inherently lower risk. That’s not to say some gapping (although rare with major Forex) may not occur, making the fill price difficult for your broker. But there will be a fill price for you to take (which shouldn’t be too far from the desired amount). Trading high liquidity markets also means you can use almost any broker – giving you the choice to select the best one for you.

DT Tip: When selecting a broker make sure the spread is as small as possible for the times of day you like to trade. Spreads can vary a huge amount. When you have been with a broker for several months it’s often worth asking for reduced spreads – they like to accommodate regular traders.

Please take a few minutes to see if you can adapt your strategy to lower your risk. Just these four simple steps could dramatically increase your bottom line.

Good trading to you all…