The Secret to Controlling Your Trading Risk

Kathy Lien - Weiss Educational Reources Contributor

In 2004, there was a movie called Million Dollar Baby where 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.”  Being defensive is the cardinal rule to surviving in the sport of boxing, a motto that is also applicable to trading.bear or bull market for bonds

Successful traders know that if you want to survive and thrive for the long term, being consistent is far more important than making one-hit wonders.

Some traders, like George Soros made most of their fortune on one trade (and in George’s case, breaking the Bank of England), but most of us don’t have enough capital to move the markets. Which is why it’s so important to protect our capital and our profits.

Reduce your trading risk

There are many different ways to reduce your trading risk and to potentially increase your profitability. One of the biggest mistakes that traders make is to take their friend’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.

Weiss Education Easy TradingWe 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

Do your homework to make sure that strategies and ideas you learn are sound. If you are proficient in coding, back test the strategies otherwise eyeball it. Scan the charts and see if the strategy works more often than not. If you can’t find any examples of it working, then it’s probably not worth following.

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Focus on the Risk

Most people who invest and trade focus on the profit potential and not the risk. This is natural human behavior, but few traders (especially new ones) realize how crippling losses can be on leveraged forex 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 favor and rally as high as 1.2300, halfway to your target.risk reward

You are elated, and decide to go to bed with the confidence that your target will 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). The number one rule of trading a 24-hour market like Forex is to use a stop.  Always know how much you are willing to lose and what it takes to make that money back.

Short and Long targets

Another way to reduce your trading risk is to use short and long targets. This means 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.

4945226-target-bullseye-e1283436807809-300x216This 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 favor, 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 too 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 favor 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 to 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.”

Until next time,

Kathy Lien

Ms. Kathy Lien is the Managing Director and Founding Partner of BKForex’s strategies and creator of the new course The ULTIMATE Forex Trading Course produced in conjunction with Weiss Educational Services.Kathy, a leading currency and Forex expert, started the #1 Forex news site, is a regular contributor to CNBC Squawk Box and is a former host of CNBC’s Forex show, Money in Motion. She is also an internationally-published author of the best-selling book, “Day Trading and Swing Trading the Currency Market” (now in its third edition) and “The Little Book of Currency Trading.”