Monday, June 8, 2009

Bigger Stop Loss or Bigger Take Profit?

This is a question that has generated a considerable amount of debate. Should a trader set a bigger stop loss for a trade or a bigger take profit? Well, these basic scenarios can occur:

1. Bigger Stop Loss, Smaller Take Profit
Winning would be easier because the market will reach the Take Profit faster than it will reach the bigger stop loss and the probability that it will reach the Take Profit would be more, assuming it really does go that way within the time that the trade is open. So you would be winning more than you lose… hopefully.
But, the money lost would be more than the money won in trades. Because when you take small profits, you do not reap in much cash, whereas when you stop bigger losses, you might be wiping out a lot of your capital.

2. Bigger Take Profit, Smaller Stop Loss
Winning would be harder and losing would be easier, the complete opposite of the first scenario. Unless the market really moves in your direction! But when you win, you win a lot more and when you lose, you lose a lot less.

What is the ideal scenario then? It would all depend on your trading strategy. If you are sure that you can win lots of small trades that can cover up for a few big losses, then you can go for the 1st option. If you would rather win less but win big and can cover up for several small losses, then you can go with 2.

But the best is still to make a good analysis, so that you can really be sure that your trade would be a winner, and then go with option 2. But only if that were that easy…

3 Golden Points of Forex Money Management

Once upon a time, I was a reckless Forex trader. This was how I would trade:

1. Make a brief analysis on the market based on charts without indicators.
2. Make a buy/sell decision based on pure animal instinct.
3. Execute a trade without knowing how much I put at stake.
4. Adjust stop loss and take profit freely

And even though at times I won trades more than lost, my balance still went down because mostly my wins were small but my losses were big. I lacked proper Forex Money Management. And that was until I learned the 3 Points. The 3 Golden Points of Forex Money Management. What are the 3 golden points? They are rules to follow whenever you want to open a trade and these rules must be followed in order. And they are:

1. Determine how much of your capital you want to risk losing on the trade - either in cash value or percentage.
2. Determine the stop-loss level.
3. Calculate the lots/units to use to trade based on your stop-loss level, capital and risked size. This is done using a formula that you have created on your own, on a spreadsheet or on a piece of paper.

Then when you have done the above 3, you can open a trade with the number of units from 3 and the stop-loss level from 2. Take Profit isn’t a big issue here. Take Profit can be bigger than stop-loss or smaller, depending on your own trading strategy. As for me, I often skip Take Profit as I like to let the market flow in my direction for as far as it would and I would manually close the trade when I notice a potential reversal.

Since I followed the above 3 points, I’ve had no problem keeping my Forex capital steady and I’ve had no problems with negative cash results that came with positive trade results, aka winning more but capital dropping. The only problems left were from faults in trading strategies.

Forex Cash Compounding

Most people who are new to Forex think that earning cash using Forex is almost like any other type of work - the more work you put into it, the more money you will get in return. And some people think that Forex is like a gamble - the more luck you have, the more trades you will win. And so, they base their trading on effort and luck, putting in more effort and crossing their fingers to try and earn as much cash as they possibly can.

While the above scenario can be workable, it is of high risk and can backfire most of the time. The Forex market, at small timeframes, is almost unpredictable to almost everyone. This is why some traders use compounding instead. How does compounding work? Well, let’s look at Forex trading as an investment instead. You invest 10000 and expect to get 1% in return, which is 100. That is not much, but it is safe. Because by doing this consistently, your cash will increase steadily. Maybe a lot slower than trying to win trades everyday, but with compounding, you do not stress yourself out watching the screens every minute every second, and you do not get to feel the high level of risk.

Have a look at 10% monthly compounding:

Month Cash
0 10000
1 11000
2 12100
3 13310
4 14641
5 16105
6 17716
7 19487
8 21436
9 23579
10 28531

As you can see, after 10 months, your initial 10000 capital would be more than doubled!