When global markets go through periods of unusual turbulence, trading spot forex becomes even more challenging. That has been particularly true of trading conditions this spring. What strategies and tactics can the forex trader employ to navigate through these times? Let’s explore a set of practical tools that can be used when markets turn chaotic.
Widen stop orders
Stops are the most common and traditional approach to risk control. When a stop price is hit, the order is executed as a market order. The problem with stops is when markets become volatile — making stops that much more necessary — the likelihood of experiencing significant slippage on execution increases. Slippage is the negative differential between the stop price and where the order is executed. During these times, the trader has to change his approach and widen stop levels. The challenge is to adjust stop levels to the extra volatility. A good rule of thumb is to set the stop at 2X the 15-minute average true range (ATR), or set the stop to equal the four-hour ATR. The ATR is a measure of the trading range over a preset period (usually 14). Using ATR automatically adjusts your stop level to market conditions.
Reduce leverage as volatility grows
The most difficult calculation a trader needs to make involves the correct position size. In the mathematics of money management, this is called the “f” factor. There is no single equation that determines the correct position size that should be placed on a trade. Spot traders commonly use high leverage in retail accounts. For example, traders putting on a standard lot ($100,000) in the EUR/USD with a $10,000 account are leveraged 10:1. A 50 pip loss at $10 per pip will result in a $500 or 5% drawdown on a single trade. Raising leverage to 50:1 on the same trade results in a 25% drawdown. Consequently, during periods of high volatility, the leverage used needs to be dialed down. A good rule of thumb is to reduce leverage by the inverse of the increase in the ATR. If ATR doubles, then leverage should be halved. What you really are doing is keeping your risk level constant. Added volatility increases risk and using ATR maintains an appropriate stop parameter but increases your exposure. Reducing the size of your bet (leverage) equalizes that exposure.
“Trouble on the way” shows that due to the May 6 “flash crash” the 15-minute ATR of the EUR/USD rose from 11 pips to 41 pips, illustrating the increase in volatility. Using the inverse ATR leverage reduction rule, the position size would be reduced to a quarter of your existing position.
Use profit limit orders
During highly volatile times, the risk of a profit turning into a loss also increases. In seconds, currency pair prices can move the other way. It is usually appropriate to tie profit targets (if you have them) with your stop levels and base them on the volatility of the market. If you don’t have profit targets and rely on trailing stops, it may be appropriate to set targets during these volatile conditions, as trailing stops can get mangled due to slippage. If your profit target is a multiple of your stop level, it will increase as you widen your stop. It is important to be more diligent in taking profits as they can disappear in an instant. This will increase the frequency of quick gains and allow the trader to get out of the way of likely quick reversals.
Scale in and out
A good way of diluting and dispersing risk is to scale into a position with half the normal position size. Only after the first position turns positive (five pips or more) should the second half be entered. This approach uses the first as a test of market conditions, which you add to as the market confirms your view. Scaling in and out of a position will enable the trader to navigate through some of the turbulence.
Finally, the choice not to trade at all needs to be considered. When markets become very difficult to trade, waiting out the storm is not a bad rule to follow. We develop models to take advantage of patterns that we detect in the markets and are successful by applying appropriate risk management to a proven edge. When we no longer can clearly identify those patterns, it is best to step aside until more normal conditions resume.
Abe Cofnas is the author of the upcoming book “Sentiment Indicators” (Bloomberg Press). He can be reached at firstname.lastname@example.org.