British Pound Drops To 13-Year Lows

The British pound remains one of the few currencies that hasn’t taken full advantage of the US dollar’s plunge. Following up on yesterday’s disappointing revision in fourth quarter private consumption, the GfK Consumer Confidence survey for February crossed the wires with a sharper-than-expected drop.

This indicator was initially scheduled for release on Friday, which added to the surprise of a -17 reading that was the most pessimistic the report has read in 13 years. Sinking confidence in Brit’s outlook for growth and their own financial position isn’t surprising considering the worsening housing slump and steadily rising prices that have eaten into discretionary spending.

Forex Money Management and The Use of Leverage

Last week we talked about the use of a 1:2 risk to reward on our trades and the use of a trailing stop to manage those trades in an attempt to be consistently profitable. But we also have to keep track of our account balance so we have funds to be in a position to take the solid trading opportunities we find.
Too many new traders will open a trade using too much leverage in an attempt to get a big win. More often than not, these trades end up as losing more money than was necessary. I recommend only risking about 5% of your account balance at any one time. If you have a mini account with a balance of $2000, then you should risk no more than $100 on a trade. This way your losses will not keep you from having the funds to take the next trade.
This does not mean to open 10 trades at once and risk $100 on each one, but to risk no more than 5% at any one time. Buying the GBP/USD and the EUR/USD at the same time is not really that different. You are looking for USD weakness in both trades which means that you are more than likely to profit on both or to lose on both. A better approach would be to open one trade risking 5% of your account balance and not open another trade until the trailing stop on the first trade is moved up to breakeven.
Then your risk on the first trade is theoretically at zero and you can now risk that 5% on a new trading opportunity. If the market is trending strongly and offering many trading opportunities, you can take advantage of the situation by having multiple positions open at the same time while still risking no more than 5% of your equity
So when you think of money management, think about how much you are risking on the trade and how much of your account balance you are risking. They are both key elements to successful trading and should be an important part of your trading approach.

Know Yourself, Know Your Setup

Who are you? What are your strengths and what are your weaknesses? Do you thrive amidst chaos or require regimentation and stability? In trading, the answers to these questions are far more important than any setup you can devise.

At its core, trading is a game of psychology, and no amount of reading, no computerized back-testing, no advanced seminar work will produce long-term success if your trading style is in conflict with your basic personality. Contrary to popular belief, successful traders do not change their approaches to adjust to the market but rather find market environments that best suit their inherent strengths.

That’s why in books like Jack D. Schwager’s Market Wizards (New York Institute of Finance, 1989; HarperBusiness, 1993) you will find very successful traders following diametrically opposite approaches to the market and often dispensing what appears to be contradictory advice. In fact, it’s not at all inconceivable to imagine two market wizards taking opposite sides of the same trade yet both walking away with a profit.

To market novices this idea may seem completely illogical. In most businesses we are taught that there is always an optimal way of doing things, that certain processes will be far superior to others. Clearly that’s the case with engineering, where scientific rules of optimization and refinement apply to everything from car production to bridge building. Financial markets, however, are emotional mechanisms, which is why engineering-based solutions to trading inevitably fail.

Financial markets are extraordinarily complex with a multitude of players, each with a different agenda and time perspective, providing the trader with a variety of opportunities for profit. Since the currency market is the largest financial market of all, the flexibility to craft a strategy conducive to your specific personality is even better in FX than in any other market.

Technical analysis –

What’s popularly called charting – can help traders evaluate both risk and reward. The technical indicators used to read the charts will give you the simplest kind of picture you can get of a currency’s performance.

Simply by placing your support and resistance and by looking at the past performance of a currency you can get a record of its closing price over time. Once all of the elements are in place for an analysis, you can calculate your pips difference and verify, depending on the trend of the market, if you will make more profit or loss and if it is after all worth the position.

For example, if the market is in a bullish situation, you need to have a higher pips difference between your buy-stop order and your resistance price than between your support price and your buy-stop order so that your reward will be maximize and your risk will be minimize.

In each case, upside (bullish) or downside (bearish), the tools of technical analysis will tell you important things about risk and reward. Don’t trade without them.

Risk and Reward

Traders have no business trading if risk/reward analysis is not at the top of their concerns. If a trader has no idea of the potential profit return on any given trade relative to the initial risk of taking the trade at all, his long-term profitability is in question.

Of course, for every trader, the best case scenario would be to minimize the first and maximize the second. But how do you get a handle on the potential reward in any investment and the risk you might be taking on?