Forex Journal

The most common mistakes equity traders make when they begin to trade Forex are:

• A failure to properly manage risk and
• Not being aware of news events that will affect their Forex positions. These mistakes are prevalent since there is such a huge difference in leverage between equities and Forex. New Forex traders need to spend time thinking about and understanding how leverage works, as well as how news and economic data will affect their trading plan.

New Forex traders coming from an equities background, who are used to trading a cash account, understand that the profit and loss of their account is correlated on a 1 to 1 basis to the Value at Risk (VAR). In other words, a 10% rise or decline in the price of the stock results in a 10% gain or loss on the cash position in their account.

Government regulations overseeing the equities markets allow traders to borrow up to 50% (2 to 1) of the purchase price of their securities for overnight positions and 4 to 1 intraday. A 10% move in a stock with 2 to 1 leverage results in a 20% gain or loss on the cash on cash position in the account. A 10% move intraday with 4 to 1 leverage results in a 40% change in the cash on cash value of the account.

Since a Forex account can be leveraged 100 to 1, a 1% move in a fully leveraged position creates a 100% gain or loss of the cash on cash value in your account. For each of the leverage changes in the previous examples, the risk associated with the position changes dramatically. With the increased leverage of Forex trading, your trade plan must be adjusted to account for a shorter timeframe in which to react to market news and or price changes. You cannot trade Forex like a poker player and go “all in;” the increased margin creates too much magnified movement in your profit and loss.

One solution offered by many Forex traders is to incorporate into their Forex trading plan the 2% rule.  Using this approach, 2% of the account value becomes the maximum amount a trader is willing to risk on a trade. This 2% becomes your “Value at Risk,” VAR or (.02 * Account Value = VAR). The VAR is divided by the pip value to determine how many pips it takes to hit your max loss. The number of pips is added to or deducted from the price bought or sold to determine placement of the stop loss.

A $10,000 account would be able to risk $200 on any one trade. A currency pair with a pip value of $10 would have the stop loss 20 pips away from the entry price. This is an easy tool that many use to help define risk within their accounts. Many experts have their own solutions to position sizing. Author Van Tharp has written an entire book, Definitive Guide to Position Sizing that outlines his premise on the absolute importance of not overdoing leverage and using position sizing to meet your objectives. It is his belief that this ONE tool is one of the most valuable, if not the most valuable tool to add to your trading system. You can read more about his solutions to position sizing at: /www.iitm.com/Definitive-Guide-to-Position-Sizing.htm

The importance of position sizing to the potential success or lack of success to the Forex trader cannot be overstated. But, it is just as important to be aware of news events affecting your positions.  There is no excuse for being unaware of news given the availability of free information on the internet today.  Equities traders have been lulled into complacency and are not obsessive about news because news events affecting stocks are often “pre-determined.”

This is an excerpt from May 2011 issue of Forex Journal.