Currency price movements have been very challenging in the past few months with wider than usual ranges. A sure sign of increased uncertainty are large wicks or tails in the candlesticks. (See “Yen's bumpy ride”). In these conditions, even the best traders can get caught by surprise with the price action moving against them. The result can be disastrous. If the trader left on a very wide stop loss, the resulting drawdown on a position often can wipe away days of trading if stopped out or cause the account to drawdown, making it difficult to put on any new trades. When caught in this scenario, the trader is hoping for a reversion to the anticipated direction that prompted the trade. Strong trading strategies, whether technical or fundamental, should not depend on hope, though.
The combination of tactics for successful recovery of an account centers on position size. Consider your average $10,000 account. Putting on a $100,000 position, moving at $10 per pip on most currency pairs (fixed at $10 per 100,000 units on EUR/USD, GBP/USD, AUD/USD, USD/CAD, NZD/USD) means that a 100 pip drawdown results in a $1,000 loss, or 10% of equity. That is for one trade. The case can be made that a 100 pip stop is too tight. Currency price movements need room to move and this means stops need to allow for wide movements. For example, a popular tactic is placing a stop at the previous day’s high or low. This approach seems reasonable but the problem is that it simply takes on much greater risk without regard to why the currency pair went the opposite direction than anticipated. Also, day ranges between highs and lows can be hundreds of pips. In the face of these drawdowns, the trader needs to shape a better recovery strategy. Hoping that the price will revert back is not sensible. In currencies, reversion to the mean is not automatic and currency pairs move in response to shifts in sentiment or surprises in economic data releases. Often the releases create significant short-term moves with the currency pair then resuming its previous direction.
Detecting why an anticipated move did not work out is key to shaping a recovery strategy. The USD/JPY and the AUD/USD provide examples on the importance of attention to fundamentals.
First, let's consider the recent USD/JPY moves. In late August it hit 15-year highs against the dollar. This led to increased chatter about Bank of Japan intervention to weaken the currency to stimulate export growth. Technically and fundamentally the price action justified a bounce. Yet, going long the USD/JPY still confronts the trader with the challenge of handling intraday drawdowns while hoping and anticipating a weakening of the yen. The USD/JPY pair was quite challenging and we can see that 100 pip extremes occurred within hours, inviting being stopped out even at 100 pip stop losses. This shows the conundrum facing the trader. Do you widen a stop and let the position swing further?
The case is strong for widening the stop because the fundamentals are strong. But tolerating wider stops needs to have with it a lower position size. By reducing the position size to $50,000 USD/JPY (five mini lots), instead of one standard size lot, a wider 200 pip stop loss does not increase the dollar drawdown potential of the trade.Though the smaller position reduces your profit potential, it keeps the possibility of recovery alive.
The AUD/USD movements offer a counter example and shows what can happen when fundamentals change and push the price to extremes -- it can keep going. AUD/USD had recently turned positive, reversing the August bearish trend. When a positive Australian GDP report came out on Sept. 1, the currency pair soared. It broke out and kept moving nearly 200 pips. Those hoping for a reversion to the mean were left with a lot of pain and a large drawdown. In this case, getting out of the way, even if a wider stop is not hit, is reasonable.
These examples demonstrate an often undervalued use of fundamental analysis in combination with trading tactics. Trading losses are expected even among the best traders, but when they occur due to ignoring fundamentals, the losses become unnecessarily large. Many experienced traders agree that the key to trading success is the ability to take losses. With every position you take, there needs to be a price level that defines failure. Sometimes volatile conditions dictate more room be given. But beyond that, it is wise to understand when and how fundamentals can change.
Abe Cofnas is the author of “Sentiment Indicators” (Bloomberg Press). He can be reached at email@example.com.
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