Risk Management

In the realm of active trading, risk management is a discipline essential to sustaining profitability. If the issue of risk is not thoroughly addressed before entering the marketplace, unexpected volatilities can wreak havoc upon the trading account. It is imperative that risk is put into the proper context each and every time an order is placed at market.

Depending upon the type of trading and market being engaged, your approach to risk management may vary. However, there are four basic actions that can be extremely useful in limiting risk exposure:

No matter if you’re trading futures, forex or stocks, the number-one reason a majority of traders are forced to leave the market is untimely capital loss. Through taking an aggressive stance toward risk management, the odds of blowing out the trading account fall dramatically.

Developing A Comprehensive Trading Plan

The contemporary marketplace is a fast-paced environment with seemingly infinite possibilities. If you’re not adhering to a strategic framework while interacting within its bounds, the potential for catastrophe becomes very real.

A robust trading plan addresses several elements essential to conducting operations in a regimented manner. The following questions must be answered thoroughly while in the process of building a rules-based approach to the markets:

Engaging the markets via a detailed trading plan limits many of the risks involved when you’re simply “shooting from the hip.” Individuals can build a statistically verifiable track record and trade consistently according to a structured approach. In turn, bad habits rooted in emotion, such as overtrading and reckless money management, may be reduced or eliminated.

Developing and following a suitable plan is the first step in eliminating many of the unnecessary risks associated with active trading. It must be easily understood and followed routinely in order to be effective. A comprehensive trading plan ensures the trader has the best possible chance of achieving replicable results.

Protective Stops And Profit Targets

Protective stops and profit targets are integral parts of almost any risk management approach. When used consistently and within the context of a comprehensive trading plan, stop losses and profit targets ensure that downside risk is limited while acceptable returns are locked in.

A protective stop or stop-loss is an order placed at market that runs contradictory to the direction of an open position. Protective stops are placed at a price level above active short positions (buy orders) and below open long positions (sell orders). Upon price reversing to the location of the stop loss, the open position is automatically liquidated or closed-out.

Stop-losses are one of the most valuable tools implemented by active traders to limit potential liabilities. They may be placed at market using any number of strategies. Protective stops are typically utilised in concert with an appropriate risk/reward ratio, technical indicator or predetermined monetary value.

Profit targets are applied to lock-in or guarantee that a gain is realised from a beneficial move in pricing. Profit targets are executed in a similar fashion as stop-losses. A limit, stop-limit or stop-market order is placed at market in opposition to the open position—sells for longs and buys for shorts.

Profit target and stop-loss order locations are largely subjective, but they’re commonly defined by using various aspects of technical analysis including support and resistance levels. The primary difference between the two is that profit targets are placed ahead of price, not behind it. When the designated price point is hit, the resting order is triggered locking in a gain.

Profit targets and stop-losses play a key role in risk management. While the stop-loss limits a trade’s ultimate downside, the profit target ensures that gains are realised and not given back in the wake of negative price action.

Balancing Risk And Reward, Understanding The Impact Of Leverage

The business of active traders is to frequently interact with a market, putting capital in harm’s way to achieve financial gain. To accomplish this task consistently and avoid abnormal account drawdowns, risk must be properly aligned with reward.

A risk vs reward ratio is a tool used to quantify the potential return and risk exposure facing a specific trade. It may be defined in terms of currency, pips, or ticks. The setting of profit targets and stop losses are key elements in developing a risk vs reward ratio.

For example, the following long trade in the EUR/USD illustrates the relationship between stop-loss/profit target location and risk vs reward:

In the above example, the use of financial leverage is held constant. While it is true that the maximum loss on the trade is 25 pips, an optimal pip value must be found. This is easily accomplished by calculating a percentage of the account balance suitable to be risked on the trade.

Concrete guidelines for implementing leverage must be included in the trading plan. In the event that an abnormally large position is taken, undue risk is assumed and a loss may be devastating. The degree of leverage placed on a single trade is best quantified in terms of available capital. Adhering to a static percentage, such as 3% of the trading account balance, is a good way of ensuring that adequate risk controls are in place.

It is important to remember that increasing the position size or degree of leverage adds to a trade’s risk exponentially. In simplest terms, the greater the leverage, the greater the risk.

Summary

By far, haphazard risk management practices are the number-one cause of new traders leaving the market prematurely. Through sticking to a comprehensive trading plan, using protective stops/profit targets, understanding leverage and the concept of risk vs reward, you can effectively limit the amount of risk exposure on a trade-by-trade basis.

Category: Trading Strategies

Leverage

Leverage is the ability to control a large quantity of an asset with a relatively small initial capital outlay.

A real-world example of financial leverage is the purchase of a home using a fractional downpayment and a larger financed balance. While the homebuyer is technically bound by the eventual payoff of the mortgage, only a much smaller down payment is required to secure the deal.

As a result, the new homeowner has taken a long position in the local real estate market, effectively controlling an asset that is worth much more than the initial cash investment.

Effective Leverage

Effective leverage is the amount of equity being used in relation to the aggregate value of an open position. Using the home purchase example, assuming a 20% down payment and a £330,000 sale price, effective leverage is calculated as follows:

Effective Leverage = Total Position Size / Account Equity

The effective leverage of the home purchase is an illustration of the amount of equity used to control the value of the entire investment, in this case a ratio of 5:1.

The active trade of currencies, futures or equities function in a similar manner to a home purchase. However, the use of liquid cash as the primary means of settlement emphasizes the concept of effective leverage. As an illustration of its impact upon a forex trade, take the following scenarios:

The effective leverage of Trader A’s account is 200:1, while Trader B’s is 20:1. The difference in leverage greatly increases the value of each pip, which in-turn magnifies the impact of short-term volatility. While Trader A stands to realise a profit 10 times greater than Trader B from a positive move, a negative move is detrimental 10 fold.

Fortunately, there are constraints placed on position sizing and the degree by which leverage may be implemented in the markets of futures, currencies and equities. Margin and maximum leverage requirements address the terms by which traders and investors are able to access credit within the marketplace:

Summary

While it’s true that leverage is a necessary component for the facilitation of trade, understanding how it works and its impact upon risk capital is an essential part of interacting within the marketplace. The inability to balance risk with reward, or to properly implement leverage can pose a challenge individual’s longevity within the marketplace.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. Kaf will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

Category: Trading Strategies

What Are Currency Carry Trades?

A currency carry trade is a method some investors use in an effort to meet their financial objectives. The basic idea behind this strategy is selling a currency with a low interest rate and then using the resulting funds to buy a currency with a higher interest rate. By harnessing this approach, an investor can try to capture the difference in interest rates, or interest-rate differential.

Carry Trades

Currency Carry Trades

Now that you have a better idea of how carry trades work, let’s explore how this concept can be applied to currencies. For starters, you could borrow a currency, such as the Japanese yen, for a very low interest rate. After doing so, you could convert the yen to the U.S. dollar and use the greenback to buy U.S. Treasuries.

As long as these U.S. Treasuries provide higher yields than their Japanese counterparts, the aforementioned transaction produces a positive carry, meaning a positive return. Lower yields would cause a loss.

For example, if you borrow ¥10,000 from a Japanese bank at 0.25%, convert it to the U.S. dollar and then use the resulting money to buy bonds that pay 2%, you stand to turn a profit of 1.75% as long as the exchange rate remains constant. Should the exchange rates change, you could sustain a loss which could exceed your deposited funds.

In the event you decide to use leverage, these returns, or losses, can increase substantially. By harnessing 10:1 leverage in the aforementioned situation, you can generate returns of 17.5%. However, using this much leverage when setting up currency carry trades can produce equally sharp losses which may exceed your deposited funds.

Keep in mind that currency carry trades do not always generate a return, and that unexpected changes in interest rates can generate losses. If you use the aforementioned strategy of borrowing the yen, converting it to the greenback and buying U.S. Treasuries, you could experience a loss should the yields on these bonds fall below the interest rate paid to borrow Japan’s currency.

If you borrowed ¥10,000 at 2% and then bought U.S. Treasuries yielding 0.25% with the resulting dollars, you would incur a loss of 1.75% as long as the exchange rate stayed constant. This loss would be amplified if you had harnessed leverage to amplify returns. For example, 10:1 leverage would make the aforementioned loss rise to 17.5%.

While this consequence might seem modest, carry currency trades can produce far greater losses. For example, a person could borrow $10,000 at 1%, convert that money to the pound and then use the funds to purchase 10-year U.K. government bonds that pay a 1.2% yield. As long as the exchange rate remains constant, the investor would make a 0.2% profit.

However, if the yield on the U.K. government bond suddenly plunged to 0.5%, this would result in the person suffering a 0.5% loss. Should the person use 10:1 leverage, the loss would increase to 5%.

Interest Rate Determinants

Currency carry traders may benefit from researching the factors that affect interest rates. For those looking to learn more about interest rates, here are some variables that are widely credited for influencing their fluctuations:

Supply And Demand: At the most fundamental level, interest rates are a function of the supply of and demand for capital. If investors and financial institutions have a high willingness to lend money to would-be borrowers, this will result in a high supply of capital. However, if these lenders are reluctant, the situation will be the exact opposite.

As for demand, aspiring homeowners, budding entrepreneurs and those seeking consumer credit (such as automobile loans) can help produce high demand for capital. However, if they are hesitant to take on debt, this desire for credit could be far lower.

Inflation: Inflation can play an important role in interest rates by impacting how much financial institutions get paid back relative to how much they lend out. If prices rise very quickly, this development could easily reduce the purchasing power of the amount that lenders get paid back by borrowers.

Alternatively, if the price level rises very slowly, lenders face less risk that the money repaid by borrowers will have weakened buying power. As a result, they may have greater incentive to loan out money at lower rates than they would in the event of higher inflation.

Exchange Rate Fluctuations

Investors may also trade by selling currencies in nations where they believe the central bank will cut benchmark rates or buy currencies in countries where they think the central bank will hike these rates.

As central bank policy decisions often hinge around business conditions, some traders are sure to stay abreast of the latest macroeconomic events.

Summary

The currency carry trade technique is widely used, as the broader foreign exchange markets frequently providers with opportunities to benefit from interest-rate differentials. However, those thinking about using such approaches should keep in mind that risk is inherent to investment. Interest-rate differentials can also generate losses. If you are considering currency carry trades, be sure to conduct substantial due diligence and/or consult an independent financial adviser.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. Kaf will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

Category: Trading Strategies

What Is Scalping?

In the financial marketplaces of the world, there are numerous different styles and trading methodologies employed with the goal of achieving profitability. One of the most prominent forms of trading used by both retail and institutional traders alike is known as “scalping.” Scalping is a trade management strategy in which the trader elects to take small profits quickly as they become available within the marketplace.

Often referred to as “picking up pennies in front of a steam roller”, scalping focuses on identifying fluctuations in price during the extreme short-term. Essentially, this trading philosophy is based on the idea that taking small profits repeatedly limits risk and creates an advantage for the trader.

The viability of scalping as a trading approach depends on several contributing factors and inputs:

There are several common methods of scalping in which short-term traders attempt to secure market share. Strategies aimed at capturing the bid/ask spread are prevalent in forex scalping, while increased leverage with the objective of harvesting minute moves in price are commonplace in the futures and equities markets.

Advantages Of Scalping

Perhaps the single largest advantage attributed to a trading approach based on scalping methodology is the limited market exposure afforded to the trader. At its core, scalping is an ultra-short-term trading strategy; therefore, the trader (and the equity in the trading account) is only vulnerable to short-term market volatilities. Typically, the short trade durations insulate the trader from greater systemic risks present in the marketplace, and limit the potential liability of each trade.

Another upside is the ability for a trader to profit from rotational or slow markets. While it is true that the most liquid and volatile markets are the primary target of many scalping operations, trading with the goal of capitalising on small market moves can prove to be profitable in stationary markets.

Often, trend or momentum-based trading methodologies struggle when faced with markets stuck in a consolidation or rotational phase. In these market states, fluctuations in price are limited, with the movements in price itself not being robust enough to reach required profit targets. Scalping eliminates the need for a directional market move to realise a profit, because small fluctuations in price are enough to achieve profitability and sustain a scalping approach.

Disadvantages To Scalping

Drawbacks to employing a trading approach based on scalping are numerous and closely related to trader discipline and psychology.

The very nature of scalping is to take small profits quickly in order to limit risk and create a consistent flow of revenue. However, in the pursuit of small profits, the scalper foregoes potentially lucrative trending markets in addition to large and directional pricing moves. In turn, it is possible for a trader to repeatedly “miss out” on trends and generous profits while adhering to the scalping trading plan. Over time, the fear of missing out on these moves can test trader discipline, lead to overtrading, and take a psychological toll on the trader thereby inhibiting performance.

Another drawback to employing a scalping approach is the increased use of leverage. To realise an acceptable profit on a given trade, scalpers often employ large amounts of leverage to boost profit. Trading for small numbers of ticks, pips or points often goes hand in hand with adding several contracts, lots or shares to the trade. Leverage acts as a double-edged sword. In the event a trade is not an immediate success, the potential liability is increased exponentially.

Summary

Scalping remains one of the most popular trading methods in the current electronic marketplace. Independent retail traders and institutional investors employ various scalping strategies in pursuit of sustained, long-term profitability. As long as the risks are clearly defined and accepted, and the proper inputs are in place, scalping can potentially provide value and opportunity to nearly any trading operation.

As always, risk is inherent to investment, so forex traders can benefit from conducting their due diligence and/or consulting independent financial advisors before participating in range trading or other strategies.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

Category: Trading Strategies

Position Trading

The active trading of securities offers individuals many ways of engaging the marketplace. Scalping, swing trading and long-term capital investment are all valid methods of pursuing profit through the buying and selling financial instruments. Falling somewhere on the spectrum between swing trading and long-term investment is the discipline of position trading.

Position trading is a strategy where traders and investors aspire to capitalise on strong pricing trends through entering and remaining present in a market for an extensive term. A position trade is a commitment of both time and money, with the intention of realising a sizable gain from the sustained growth of an open position’s value.

Elements Of A Position Trade

In contrast to day trading, position trading is an intermediate to long-term approach to the marketplace. The typical duration of this type of trade is measured in weeks, months and years. Instead of implementing an intraday perspective using seconds, minutes and hours, decisions are made referencing daily, weekly, monthly and yearly timeframes.

Successful trading is dependent upon many factors, with each style having unique elements crucial to its effectiveness. In position trading, there are a few aspects of function that are essential to the viability of the approach:

It is important to remember that the primary goal of position trading is to capitalise on a strong trend. Identifying opportunities with adequate risk vs reward ratios, in addition to entering and exiting a market efficiently, are imperative to the success of the approach.

Advantages To Position Trading

While the optimal duration of a position trade depends upon several factors unique to each specific product, holding an open position in any market affords traders and investors several inherent advantages:

The advantages of position trading appeal to a wide array of individuals. People who do not have the time necessary to trade on an intraday basis find position trading a great way of engaging the financial markets. In addition, many traders prefer to make infrequent decisions and avoid getting caught up in the periodic turbulence intraday trading often provides.

Disadvantages To Position Trading

While the logic behind the implementation of a position trading strategy is alluring to some, there are several unique disadvantages. As stated earlier, taking a position for a considerable period of time is a commitment. Getting “cold feet” and making an unplanned, early exit from the trade may serve to compromise the integrity of the entire strategy.

Listed below are several drawbacks to the practice of position trading:

The disadvantages to position trading are worth consideration. Tying up risk capital for an extended period can come with great opportunity cost, both in terms of missed trades and the inability to compound returns. In addition, the psychological impact on the trader can be extensive as position value fluctuates, or as an unforeseen development shakes up the marketplace as a whole.

Summary

As with seemingly everything in the financial arena, the strategy of position trading comes with upsides and downsides. Many individuals find the possibility of realising sizable gains through catching a trend attractive, while others are leery of being exposed to the possibility of a widespread financial collapse.

The decision of how to engage the markets lies within the individual. While position trading is a great fit for some, it can be a detriment to others. The responsibility for selecting an optimal trading methodology also lies with each aspiring trader or investor. If the appropriate time, capital and personality is present, then a strategy of position trading may be ideal.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. Kaf will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.

Category: Trading Strategies