From the March 2014 issue of Futures Magazine • Subscribe!

How to avoid blowups

The process of constant recalculation is key. If you keep risking your original $200, which is a mistake many traders make, it will quickly become a much higher portion of your account than just 2%. Assuming constant recalculation, you can theoretically lose an infinite number of trades and never blow up your account. Obviously, in the real world, you are limited by your account size and a market’s minimum position requirements. However, assuming sensible starting capital and with the facility to trade fractional lots, it will be a long time before you are unable to resize your risk to meet the requirements of maximum exposure.

An important thing to remember when using this rule is you must take into consideration the relationship between the assets you are trading. Two different positions in related markets may increase (or decrease) your risk exposure accordingly (see “Big picture,” below).

The first chart in “Big picture” shows the last quarter of 2013 in the EUR/USD. The second chart covers the same period for the USD/JPY. Notice on Oct. 25 (highlighted), the euro ran into resistance against the dollar at around 1.3830 and reversed to the downside. On the same day, the dollar found support against the yen around 96.90 and reversed to the upside.

This is no coincidence. Whatever the reason for the reversal — in this case, it was partly fueled by better than expected U.S. durable goods data — the dollar gained strength and established a positive trend against both the euro and the yen. This is a common occurrence in the currency markets. You must take these relationships into consideration when calculating your total risk exposure. Both a long trade in the EUR/USD and a short trade in the USD/JPY are dollar shorts. If you risk 2% on each trade, your total dollar short exposure is 4%.  

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