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How to Reduce Your Trading Risk By Kathy Lien

In Million Dollar Baby, a 2004 film about boxing, a trainer played by Clint Eastwood said to a boxer played by Hilary Swank, "The number one rule in boxing is to protect yourself, protect yourself, protect yourself."

When it comes to trading, it too pays to be defensive. Successful traders know that if you want to survive and trade for the long term, consistency is far more important than one-hit wonders. Some traders, like George Soros, may have made most of their fortune and name on one trade (and in George's case, breaking the Bank of England), but most of us small fish don't have enough capital to move the markets.

If this applies to you and you are interested in reducing your trading risk, it may be more useful to learn how to trade defensively. This is particularly important for forex and CFD traders, because high leverage can cause wild volatility in your profitability.

Reduce your trading risk

There are many different ways to reduce your trading risk and to potentially increase your profitability. The best way is to know what you are doing. Of course, that is easier said than done.

One of the biggest mistakes that traders make is to take someone's advice without doing any homework. Too many shirts have been lost from this simple mistake. Take the technology boom, for example. Equity traders aggressively ploughed into companies that were taken public with negative earnings and business plans that were probably scrawled on napkins.

We should have all listened to Warren Buffett's advice of "buying only what you know." This mistake happened again in 2008, when everyone ploughed into the long oil trade as it was rising towards $147. At the time, analysts were saying that global supply was shrinking. In reality, six months before oil prices hit a peak, supply was increasing and demand was decreasing. In fact, it was widely known that oil prices were driven higher by nothing more than speculation. These big misses were mistakes made by many investors.

Do your homework

On a day-to-day basis, traders may find strategies or ideas that they read online or learn at tradeshows. It is extremely important to do your homework to make sure that the ideas are somewhat sound. If they are not, the consequences can be grave. If you are proficient in coding, the strategies can be back-tested. Otherwise, just do an eyeball test. Scan the charts and see if the strategy works the majority of the time. If you can't find any examples of it working, then it may not be worthwhile following the strategy.

Most people who approach trading focus on the profit potential and not the risk. This is natural human behaviour, but few traders (especially new ones) realise how crippling losses can be on leveraged forex or CFD positions, and how much return it would take just to get their account back to even.

For example, let's say you have a USD$5000 forex trading account and you decide to buy one standard lot of the EUR/USD at 1.2200, with each pip move worth USD$10. Your goal is to close your position if the EUR/USD reaches 1.2400 and for whatever reason, you decide to not use a stop (which is another common mistake made by new forex traders). You watch the EUR/USD move slightly in your favour and rally as high as 1.2300, halfway to your target. You are elated, and decide to go to bed with the confidence that your target will be hit when you wake up. Unfortunately, when you do wake up, you take a look at your trading screen and see that the EUR/USD has fallen 125 pips to 1.2075 and you are down $1,250 (125 pips x $10).

Nothing is guaranteed

You stick with the position because you think that 1.20 will be a strong support level and it will bounce. Unfortunately, it breaks the support level and hits 1.1950. At that time, you are down 250 pips or $2500 and you decide to cut your losses. When you assess the damage, you see that your account equity has fallen from $5000 to $2500, a loss of 50 percent.

Some of you may say "I will never let my account fall 50 percent," but a 250 pip move in the EUR/USD can be a one- or two-day move. In order to restore the account back to $5000, you would need to make a return of 100 percent. If you were lucky and your target was hit in the morning, you wouldn't have this problem - but gains can never be assured.

The first rule of trading is to always know how much you are willing to lose and what it takes to make that back. Two other things could have been done differently to reduce trading risk - use a stop and lock in some profits when the EUR/USD rose to 1.23.

High probability vs. high profit trading

Most traders focus on what we call "high profit trading," but if you want to reduce risk and protect your capital, it may be more lucrative to practice "high probability trading." Some of you may roll your eyes when you hear fellow traders say they only aim to make 10 pips per trade, because it is far too small for your high profit goals and you believe that 10 pips is just noise. However, don't criticise it too much - five profitable trades a day making 10 pips each at $10 a pip comes to $500. Of course, this type of strategy requires a high percentage of profitable trades.

In general, "high profit trading" applies to strategies that have a 2:1 risk to reward ratio or better. This means that a trader expects to make $2 for every $1 risked. With this type of strategy, you can be right 40 percent of the time and still be profitable.

For "high probability trading" strategies, the risk to reward ratio is usually 1:1, and therefore you need to be right closer to 60 to 70 percent of the time to be profitable. However, by going for high probability but low profit trading, you are focusing on consistency and not relying on a few big winners that you may end up missing.

Minimise your risk and protect your profits

Another way to reduce your trading risk is to use short and long targets. This means to exit half of your position at a relatively conservative, easily achievable profit target and then trail the stop on the remainder of the position in the hopes of riding the move for as long as possible.

This is particularly useful in the foreign exchange market because of the trending nature of currencies. Imagine that you decide to go long the EUR/USD at 1.2200 with a stop at 1.2140. As the currency pair moves in your favour, you decide to take half of your position off at 1.2250 and trail your stop on the remainder of the position by 35 pips.

The key, however, is to move your stop to breakeven on the second half of the position once the first target is reached. This way, you have banked 50 pips even if you are stopped out on the second half of the position at breakeven (1.2200). If the currency pair continues to move in your favour you will lock in more profits. With this type of money management strategy, you are basically pocketing nickels along the way as you wait to catch a big trend.

Trading defensively and protecting your profits is very important because without capital, you will not be able trade another day. As Rocky Balboa once said, "It ain't about how hard you hit; it's about how hard you can get hit and keep moving forward. That's how winning is done."

Kathy Lien
Kathy Lien

KATHY LIEN is Managing Director and Founding Partner of BKForex Trading Signals and BK Asset Management. Having graduated New York University 4 years early, Kathy started working on Wall St at the age of 18.

Her career started at JPMorgan Chase where she worked on the interbank FX trading desk making markets in foreign exchange and later in the cross markets proprietary trading group where she traded FX spot, options, interest rate derivatives, bonds, equities, and futures. In 2003, Kathy joined FXCM and started DailyFX.com, a leading online foreign exchange research portal. As Chief Strategist, she managed a team of analysts dedicated to providing research and commentary on the foreign exchange market. In 2008, Kathy joined Global Futures & Forex Ltd as Director of Currency Research and in 2012, she decided to branch out on her own with Boris Schlossberg to start BK Asset Management.

As an expert on G20 currencies, Kathy is often quoted in financial newspapers worldwide and appears regularly on CNBC. Kathy is an internationally published author of Day Trading & Swing Trading the Currency Market, The Little Book of Currency Trading and Millionaire Traders: How Everyday People Beat Wall Street at its Own Game.