For forex traders, there is a constant focus on the search for a good trade. But successful forex trading involves much more than selecting direction. It requires managing the total account. Even a good trader can lose control if careful attention is not paid to the relationship between the balance of the account and the equity of the account. The balance is the accumulated cash in the account. Equity is the value of the account, if it was closed at that moment.
As trades are closed, whether profitable or not, the balance changes. For example, if one starts with $100,000 and closes a trade for 10 pips at $10 a pip, the balance would increase to 100,100. A losing trade would reduce the balance. This seems clear enough, but the problem occurs when there are open positions that are carrying losses. Traders often close winning positions quickly and leave open losing positions. The effect is that the balance is increasing, while the equity in the account is decreasing. Many traders see the balance as more important than the equity in the account. After all, a trader who is putting on many positions and closing them for profits appears to be adding to the balance. At the same time, the trades that are open and losing equity “could” revert back into profits. Almost all traders have experienced the anguish of closing an open losing position, only to have it turn around soon thereafter. Of course, the key word is “could.” Many good trades often experience an initial duration of a loss. First, the spread cost has to be made up. Perhaps the currency pair is probing a key technical level and may therefore be positioned for profits. There is no doubt that unless the trade is a momentum trade that immediately catches the move, many winning trades start as losers.
By leaving open losing trades on, the trader is anticipating a turnaround. This anticipation may be based on a fundamental or technical view of price. It is, however, more likely to be influenced by the trader’s reluctance to acknowledge he is wrong. Accepting error is difficult but essential.
Many traders reason that open position losses are “noise” and temporary and they could be right but there needs to be an objective price-based definition of being wrong a trade. Consider a $10,000 account with four currency pairs that are open but totaling $20,000 each in size for a total exposure of $80,000. This means that for every pip against the account, the value will shift $8. If each currency pair was 50 pips down, for a total of 200 pips, then the account equity would be down $1,600. Is 16% a reasonable range for a drawdown in a currency account? There is no definitive answer, but there are clear warning signs.
The most important is the leverage; $80,000 in the size of open positions means that the leverage is 8X the equity. Fifty-pip moves in currency markets is very common and can easily become greater. When a position is open, the trader tends to focus on the losing position and as a result such a focus prevents effective analysis of new opportunities. The losing position is actually tying up more than trading capital; it is preventing the trader from acting on new opportunities. Open losses of long duration reduce trader effectiveness. What then should be the approach to open losing positions?
One approach is “correlation hedging.” The trader can take a position that would offset the loss exposure. For example, if the losing trade is in a EUR/USD, a trader could put on an offsetting position in GBP/USD or in USD/CHF (see “Currency pair correlations”). The trader should carefully review which pairs offer the best correlations because these correlations change from week to week.
A second approach is trend alignment. The trader should avoid trading against the orientation of the trend. I suggest using a four-hour chart to determine the overall trend.
Regardless of everything else, a trader needs to have a definitive stop loss level intended as a worst case scenario. The average true range (ATR) indicator on a daily chart is a good tool for selecting stop levels (see “Stop selection”).
Using the ATR recognizes the need to allow for volatility but still impose limits. If these broad stops are not sufficient, the trading strategy itself needs to be questioned.
The best risk control is not putting on over-leveraged trades. Many traders will not let a single trade risk more than one or two percent of an account. This is a good model that provides an objective definition of being wrong a trade.
Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at firstname.lastname@example.org