If you could tap into the brain of someone that worked at a broker for 14 years (partly as a trader and partly as a risk manager), what is it you would want to know? This is what I ask myself when I starting writing any blog article. One thing that keeps coming to mind is risk management.
Brokers have the same goal that traders have: make as much money as possible with as little risk as possible. Good brokers are really good at managing risk. So what about how a broker manages risk can help you manage your risk?
What brokers do (and don’t do) to eliminate risk
Let’s start with what FX brokers don’t do when managing risk. They don’t know where the market is going. They don’t worry about where the market is going. They don’t look at a chart or at support/resistance levels. The decisions they make help protect them as much by what they don’t do as by what they do. And, they don’t look at the market when making most of their decisions.
There are exceptions to this rule, like when the Swissy was pegged to the Euro or when the Bank of Japan is intervening at specific levels. These are the exceptions to the rule. Brokers have to have specific rules to follow to eliminate risk regardless of market conditions, and they need to be automated or easy to follow so that they are covered during times of extreme market movement.
So, what does an FX broker do to manage risk?
First, and most important, is that they study, plan and analyze data in their decision process. Every plan has to work for that broker and that broker’s set of customers. I’ve worked for two brokers, and they managed risk differently. Even the first broker I was with changed how they did things as the market and their customer changed over the years.
Secondly, FX brokers treat different risks different ways. They have different plans for different customer types (or books of business). Every type of trading falls into different books of business and is treated in the best way to maximize PNL (profit and loss) while decreasing risk. Your strategy isn’t that much different from some other people’s strategies, and you get grouped with like traders in the broker’s book of business.
Thirdly, FX brokers have multiple liquidity partners or banks. They work with many different banks, and they know that each bank is good with different things. Some are good with smaller volumes. Some are good with certain currencies. The best part of having numerous liquidity partners is that you have choices. If one isn’t working out well for you, you can use one of the other banks.
Have a Plan
Here is something I learned while managing a trading desk:
When you make a mistake in managing risk, the market never goes in your favor…and I mean never.
So, when you are constructing a plan, you need to consider all the possibilities and eliminate the risk wherever you can. Planning includes having a trading strategy you trust and having good risk/reward, but it goes beyond these things.
Here are some things to help you take your trading plan to the next level:
Position Sizing
Many questions need to be answered when determining position sizing. Does my trading strategy dictate position sizing or adding to my position? How much am I willing to risk per trade? What available equity do I have? How much am I willing to risk per day? What leverage am I using?
When trading stocks, I will typically only put 5% of my account into any one trade. So, if I have a $100,000, I will only by $5,000 worth of one stock. This is for solid, trusted companies. If I am going to trade something a little bit more risky (like a shale oil company), I will limit myself to 2% or less. It really depends on my rolling expectancy ratio. I tend to risk more when this ratio is above my threshold.
Now, with futures or forex, I am a bit more leveraged, but I will limit myself to 1% of my available equity. For example, a EURUSD trade with a 20 pip stop loss and a $100,000 account would give us a 500,000, or 5 standard lots, position size. How did I get there? I am risking $1000. Divide that by the stop loss of 20 pips. Lastly, divide that by the pip value of $10 giving you a position size of 5 lots.
Cutting losses and letting winners run
What is your exit strategy? Before entering into a trade, you must know what the goal is and what will make you get out of the trade. In other words, how much are you willing to risk on this trade. This means working orders…especially a stop order. Stop orders are key for risk management, and a trailing stop is a good way to allow your winners to run. When you are work stop loss orders, are you letting them do their job in protecting you, or do you move them when they are close to getting filled?
Some traders like to exit part of their trade and realize profits on that part. Others are very successful adding to positions as they go in their favor.
In 2008, I saw a trader take his $15,000 account up to $800,000 during those super volatile times, and they did it by adding to their position as the market went in their favor. Now, keep in mind that they were not able to exit the position until they were back around $400,000 because they were trying to exit during extreme market volatility. A trailing stop would have been very advantageous to them here.
Know when to turn your strategy on/off
There is more to knowing when to trade than looking at a chart, finding a good setup or following someone’s trading signals. You need to know your own trading.
One of the most overlooked parts of trading is knowing when to stop trading a strategy. Most traders focus their attention on the entry and exit rules only. Money management and having a plan to turn off a strategy when it starts failing are completely missed.
I have seen traders lose a lot of money because they were emotionally attached to their strategies and had no idea of when to stop trading them.
Traders can have the opposite problem as well. They begin to jump from one strategy to another as soon as they have a few losing trades. They do this because they do not know their strategy enough to have the confidence to stick with it. Part of good planning is knowing your strategy inside and out.
Most traders are streaky traders. They tend to have profitable trades in bunches and losing trades in bunches. If your trading runs in streaks, knowing when to turn on and off a strategy can allow you to trade when you are more likely to succeed and stop trading before large drawdowns.
This can be done with different types of equity curve trading, including equity curve moving average, rolling expectancy ratio, rolling percent confidence and rolling win rate. Finding a robust, specific metric for turning on/off a trading strategy can have a significant impact on you trading profits.
Awareness
Any good plan should take into account what is going on with the product being traded. Is something happening in the country, company, or market that you need to consider? Are there any news events that could cause your trade problems? How about geopolitical events happenings?
Near the beginning of the Russia Ukraine conflict, we were trading Euro-Bund futures. Any update pointing to a larger conflict, immediately sent the Bund shooting up. We did not want to be caught short on one of those moves.
What support resistance levels are there on other product’s timeframes? If you are day trading, are there long term trends that could cause problems with your short term trend strategy?
Hedges
There are whole strategies around options that can really help limit risk while providing decent upside. Can you utilize options to help eliminate some of your risk? It can be as simple as selling puts that are below the current market instead of entering the market directly. You might not actually get a position in the underlying, but that’s ok because you will receive the premium for selling the put.
Another choice might be to sell calls on positions you have. This allows you to generate some extra profit while holding a position. If you sell calls that are above the market, you are essentially getting paid to enter a limit order.
What about trading another product that could eliminate some of your risk? A forex example would be to hold long positions in EURUSD and USDCHF. They don’t always move together, but quite often they do.
Non-correlated strategies
The last thing I will touch on today is trading multiple uncorrelated strategies. Some traders like to specialize in doing one thing really well. That isn’t necessarily a bad thing, but what happens when the markets start to change (and they always change)?
To truly minimize risks from different market regimes, you can trade multiple non-correlated strategies with positive expectancy. Let’s call this diversification of trading strategies. It’s similar to how a broker minimizes it’s risk by having a plan for different types of traders, or how they have multiple banks to offload their risk.
Trading multiple non-correlated strategies typically lead to smoother return streams and smaller drawdowns. Think efficiency frontier for trading strategies instead of investments.
There is a ton of information in this post. When you sit down to trade, you only answer to you so make a plan that works for you. You should always adapt any information you receive (trading strategy, blog post, or trading tool) to fit you and your personality. Don’t try to be something you are not. Take what works for you and use it to improve your trading.
Guest post by Steve Nauta of Daticks
Share
