Volatility is the rate of the change in price over a specific
period. The faster price rises or falls through time, the higher
the volatility is. Volatility is calculated as the standard deviation
of the percentage change in the daily price. Simply put,
the faster a market moves in one direction, the more volatile it
becomes and the more likely we are to see above-average price
movement relative to previous price behavior. Another way to
say this is that the higher the volatility in a market is, the more
money a trader will have to risk per trade.
One way traders can limit their risk is by using stop-loss
orders. What’s important for traders and investors to know
about stop-loss orders is that although they work most of the
time, there is no guarantee they will be filled at your price or,
in forex markets, filled at all. There are times when markets can
gap higher or lower, particularly on the Sunday opening, leaving
a stop order filled at a different price or not filled at all.
Because of this possibility, it is best to monitor your account at
all times when you are in the market.
In our trading accounts we always look to risk no more than
2 percent per trade or 6 percent per day of our risk capital. If we
are sizing up a setup or trade and determine that the risk is outside
our parameters, we do not take the trade. Before we cover
risk, though, we need to understand the dangers of margin.
In commodity futures you often can control 100 percent of a
commodity by putting down 3 to 7 percent of the cost of the
physical commodity. An example is gold. In a commodity
account you can buy 33 ounces of gold or one mini gold contract,
worth approximately $29,700, for $1,100 down. The margin
for gold thus is 27 to 1: $1,100(27) $29,700. The danger in
this is that if you bought a mini gold contract in a $5,000 account
and gold moved lower by $35 per ounce—as it did on August
11, 2008—and you did not have a stop order placed, you would
have lost over $1,100, or 22 percent of your account, in one day.
Margin is always a dangerous proposition for untried traders,
but when combined with volatility it is treacherous.
In futures we have mini contracts, yet with the surge in
volatility in commodity prices over the last several years, many
smaller account holders have been priced out of the market as
they have been forced to risk higher percentages of their
account balances. In forex the margins are even higher, and that
makes it more treacherous for novice traders. Margin in forex
can range from 50 to 1 all the way up to 400 to 1. However,
aside from the standard contract, which has a $100,000 face
value and can be controlled with $2,000 down at 50 to 1 or with
$1,000 at 100 to 1, there is also a $10,000 contract that can be
controlled for $100 at 100 to 1 and a $1,000 contract that can be
controlled with $10 down at 100 to 1. Because of these smaller
contract sizes, it is easier to stay within the 2 percent stop-loss
rule whether you are trading a $10,000 account or a $1,000
account. It is important to remember, however, that whatever
the margin rate is, if you are wrong on a trade, you will lose
the full percentage value loss of that instrument; that means
that if you go long a standard 100,000 EURUSD contract and
the euro drops 2 percent that day against the U.S. currency, you
will have lost $2,000.
When we are short-term trading, or day trading, we generally
don’t plan on leaving the screen while we are in a trade. We
try to go with multiple contracts that give us the freedom to take
a portion of our position off at a profit that is based on market
structure and short-term behavior, letting us to allow the balance
to run on the basis of longer-term market behavior. If we are
trading longer-term time-frames, or end-of-day—using a daily
chart—we will trade at least one contract. Before taking a trade,
we figure out what 2 percent of our risk capital is (0.02 multiplied
by the net liquid value of combined futures and forex
accounts), and this is the amount we can risk per trade. Along
with giving you your stop-loss, or the amount risked on the
trade, this amount will help determine your lot size.
For example, let’s say your risk capital accounts are $10,000,
and so you may risk 0.02(10,000) $200. We may know from
experience that our risk per trade on the British pound is
approximately 30 pips per contract, or $30 per mini contract.
Thus, if we can risk $200 on a day trade in GBPUSD, we divide
$30 into $200 and get 6.66. We round down to 6, which means
we can trade six minis, or a $60,000 block of GBPUSD, and we
must put a 30-pip stop on that trade once it has been entered.
Therefore, if we sell six minis at 198.00 on a day trade, we need
to place a buy stop at 198.30. If that distance seems too short
and thus unreasonable in light of the volatility in the market
and the structure on the chart, we pass on the trade or put on
fewer contracts. If we choose to take a position trade for
a longer-term period, we can sell two at 198.00 and place a
90-pip stop or a buy stop at 198.90 to keep the possible loss at
2 percent; similarly, we can sell one short GBPUSD at 198.00
and place a buy stop up at 199.80, or 180 pips above the short
position, to maintain a 2 percent loss.
Getting back to the six-lot day trade, by risking just 2 percent
in GBPUSD, we would be able to take at least two more trades
in other pairs. Alternatively, we could choose to risk 1 percent, or
$100, that is, three mini contracts, or a $30,000 block in GBPUSD
and have the freedom to trade up to five more pairs, keeping the
total risk per day to approximately 6 percent of the risk capital.
This way we have room to day trade several positions or position
trade several pairs and keep our total exposure to 6 percent.
If there is an adverse move against our positions, we adjust our
stops and risk accordingly, always maintaining a total exposure
of just 6 percent on all open positions. If our account draws
down, so does our exposure on future trades. As the account
grows, we’re able to increase our trading size. By placing the
physical stop we learn discipline and also are assured of maintaining
a reasonable risk-reward ratio by professional standards
if something unforeseen happens in our lives or in the marketplace.
Always remember to check to see if you have any active
working stop orders when you exit your trading platform.
Source: Mastering the Currency Market: Forex Strategies for High and Low Volatility Markets
