Part IX Trading Strategy
9.4. When To Exit The Trade?
capital of $5,000 and if you trade on 1:50 margin, you can control $250,000 with your capital. However, a two percent move against you and your capital is completely wiped out. If you are a beginning trader you should not use more than 1:10 margin until you get comfortable and profitable and then and only then you can attempt to use higher margins up to 1:20. What does 1:10 margin means? It means that with your $5,000 you will control $50,000. Let’s say you are trading EUR/USD and by using our entry strategy you have decided to enter the trade on a long side. That means that you are betting that USD will depreciate against EURO. Let’s say current EUR/USD rate is 1.1584. Again, if your trading capital is $5,000 and you are using 1:10 leverage you will effectively be exchanging $50,000 to Euros. If the current rate is 1.1584 you will receive 50,000/1/1584
= 43,163 Euros. If the trade goes in your direction that margin will work in your favor and 1% decline in USD will mean 10% increase in your start up capital. So if EUR/USD rate moves from 1.1584 to 1.1699, you will be able to exchange back your 43,163 Euros
* 1.1699 to approximately $50,500 for a profit of $500. Since your start up capital was
$5,000 it is effectively a 10% increase in your account. However, if the trade went against you and USD dollar appreciated 1% vs. EURO your account would be reduced to
$4,500. You can then imagine what would have happened to your account if you were trading with 1:50 margin. If you are trading currency futures it works in the same way although the minimum amount that you can buy is one contract. For example Canadian Dollar contract size is $100,000, Swiss Franc contract size is 125,000 SF, Euro Currency contract size is 125,000 EURO, E-mini Euro contract is 62,500 Euros. Initial margin requirement to purchase 1 E-mini Euro contract is $1,215. So with $1,215 you are controlling approximately $70,000. That is approximately 1:50 margin, however by having additional $5,000 in your account your margin will effectively be 1:10.
9.4.1. Cut Your Losses Short
Immediately after our entry order is executed we will fully concentrate on our exit.We need to decide how much capital can we risk on one trade. Let’s assume that our trading capital is $5,000. This is where it gets tricky. You have probably heard hundreds of times that you need to protect yourself against large losses in order to protect your start up capital. However if by cutting your losses short you think running out of a trade like a scared rabbit as soon as the trade goes against you, you will be in a big trouble. You CAN NOT trade currencies in such fashion. The stop loss strategies that may have worked when trading highflying stocks of the late nineties DO NOT work in currency markets. If you try to scalp currencies you will lose your shirt. The key to currency trading success is to catch a large multiday/multiweek swings. You will not be able to do that if you don’t give your trade a chance. By properly implementing our entry strategy described above you have done everything you can to enter the trade with a high probability that it will go in your direction. However, it doesn’t mean that it will do so immediately after you placed a trade. You need to give it some space. How much space? Enough space so that you don’t get stopped out all the time while at the same time tight enough so that if you are wrong you preserve majority of your capital to fight another day. Our first rule is that we will not risk more than 5% of our capital on any single trade. Therefore if our capital is $5,000 our maximum loss on any trade will be $250.
9.4.2. Where to place your stops?
After we have entered a buy order we will place our stop loss just below the nearest line of support (PDClose, PP, PDLow, Lower Trendline, Fibonacci Retracement).
If it is not possible to place our stop loss below the nearest support line and still keep our stop loss at less than 5% we will have to move it up and make it a maximum of 4%.
If we have entered a short sell order we will place our stop loss jut above the nearest line of resistance (PDClose, PP, PDHigh, Upper Trendline, Fibonacci Retracement). We can do so only if total possible loss amounts to less than 5% of our trading capital. If it is not possible to place our stop loss above the nearest resistance line
and still keep our stop loss at less than 5% we will have to move it down and make it a maximum of 5%.
We will use one of the examples from before to illustrate the point. Let’s say you are trading EUR/USD and by using our entry strategy you have decided to enter the trade on a long side. That means that you are betting that USD will depreciate against EURO.
Let’s say current EUR/USD rate is 1.1584. Again, if your trading capital is $5,000 and you are using 1:10 leverage you will effectively be exchanging $50,000 to Euros. If the current rate is 1.1584 you will receive 50,000/1/1584 = 43,163 Euros. Now we have to calculate how many points you can lose before you reach 5% of your capital. Since you are using 1:10 leverage 5% loss will represent 0.5% change in the current EUR/USD rate.
1.1584 – 1.1584*0.005 = 1.1584 – 0.0058 = 1.1526 If the nearest support line is below 1.1526 we will place our stop loss at 1.1526.
If the nearest support line is above 1.1526 we will place our stop loss just below (about 10 points) the support line.
If our stop loss is reached we will get out of the trade immediately, no questions asked. You cannot cut corners with the stop loss rule. It needs to be followed every single time without exception. Failure to follow the stop loss rule is the number one reason for failure among beginning traders. It is true that sometimes price will turn around just after you get out, but there is no way to know this in advance. It only takes a few stubborn incidents to entirely devastate your initial trading capital.
9.4.3. Let Your Profits Run
Once you are in the trade and the price has started moving in your direction, you need to extract as much profit as possible. Not being able to do so will make you a losing trader in the long run. How can a trader lose if he only takes small profits at a time? Profit is profit, isn’t it? Not exactly… Profit of $550 is not the same as a profit of $850. If such profits are followed by three losses of $200 each, profit of $550 will become a $50 loss, while profit of $850 will become a $250 win. Do you get my point? Profits are always followed by losses and if the profits are small they will not make up for the losses that
will eventually and surely follow. However, becoming too greedy can turn a small profit into a loss. This will also make you lose money in the long run.
The best solution to resolving these conflicts is to use trailing stops.
9.4.4. Trailing Stops
As the name says, trailing stop follows the price that is moving in your direction.
For example let’s say that we have entered a EUR/USD trade at 1.1584. We will automatically put our stop loss just below the next support line or if that is over our 5%
limit we will put our stop loss at 1.1526. The price starts to move in our direction and it rises 0.5%, so the current rate is now at 1.1584 + 0.005*1.1584 = 1.1642 We will now sell one half of our position in order to protect some of our profits and we will move our stop loss up by using this formula:
CurrentStopLoss = PrevStopLoss + (PrevPrice - PrevStopLoss) * 0.75 where CurrentStopLoss is calculated every time the price moves another 0.5% in the direction of our trade.
If we were trading currency futures we can sell half of our position only if we were trading two contracts. If we were trading one contract only than we will use trailing stop as well as we cannot sell half of the contract.
What type of order should you use when exiting the trade?
When entering a trade I have recommended using a limit order because you can afford not to take a trade at a price that doesn’t meet your standards. When exiting a trade the opposite is true. You cannot afford to stay in a bad trade. Therefore, when exiting we will use market order, which will get us out of the trade quickly, even though it will cost us additional spread points.