RISK MANAGEMENT

There are three basic questions that every trader should answer BEFORE entering a trade.

How much do I believe the market will move and where do I want to take my profit?

Limit Orders allow traders to exit the market at profit targets. If you are short (sold) a currency pair the system will only allow you to place a limit order below the current market price because this is the profit zone. Similarly if you are long (bought) the currency pair the system will only allow you to place a limit order above the current market price. Limit orders help create a disciplined trading methodology and enable traders to walk away from the computer without constantly monitoring the market.

How much am I willing to lose before I exit the position?

Stop/Loss orders allow traders to set an exit point for a losing trade. If you are short a currency pair the stop loss order should be placed above the current market price. If you are long the currency pair the stop loss order should be placed below the current market price. Stop/Loss orders help traders control risk by capping losses. Stop/Loss orders are counter-intuitive because you do not want them to be hit, however, you will be happy that you placed them! When logic dictates you can control greed.

Where should I place my stop and limit orders?

As a general rule of thumb traders should set stop orders closer to the opening price than limit orders. If this rule is followed, a trader needs to be right less than 50% of the time to be profitable. For example, a trader that uses a 30 pip Stop/Loss and 100 pip limit orders, needs only to be right 1/3 of the time to make a profit. Where the trader places the stop and limit will depend on how risk-adverse he is. Stop/Loss orders should not be so tight that normal market volatility knocks the position out. Similarly, limit orders should reflect realistic expectation of gains given the markets trading activity and the length of time one wants to hold the position.

Test Your Skills

If you haven’t already you will need to register for a Friedberg Demo Trading Account and download the Free Software. Click here.

1. Buy three different Euro positions. Place a 20-point stop order,
   35-point stop order and a 100-point stop order.
   
   
2. Buy three more Euro positions. Place a 20-point limit order, a
   70-point limit order and a 200-point limit order.
   
   
3. Buy one Yen position and place a 30-point stop order and a
   100-point limit order. Now buy one more Yen position without a
   stop or limit order