In life some things are guaranteed, like death and taxes. Similarly, in forex trading, you are guaranteed to suffer a few losses occasionally no matter how good your forex trading strategy is.
What separates the winners from the losers is how you handle those trades that run into losses. You should be familiar with the most common saying in all financial markets and make it a mantra.
That is, “cut your losses and let your profits run”. That is a very practical piece of advice which you should always stick to since one bad trade can wipe out your entire forex account even if you were just from a winning streak for the last one hundred trades.
All said and done, knowing when to cut your losses provides the greatest challenge for most traders.
You may prematurely exit a trade only to see the price action reverse to the direction you had previously expected and end up making a loss where your trading strategy had correctly predicted high profits.
At the same time, you may dilly dally a little bit hoping for this reversal only to make your situation worse and end up suffering much higher losses than you can manage.
So how do you know when to cut your losses?
1. Follow the Market
Following market information and the various technical levels that might have an effect on your forex trade positions act as an early warning system for impending losses.
Forex charts are especially useful in identifying trends and predicting any trend reversals. Financial and political news events may also play a significant role in price directions of the positions you are holding.
Forex traders with high experience levels can also be a good source of reliable information and you can access their opinions and commentaries from broadcasts and blogs.
For example, going for a Rakuten open account can allow you start trading and follow the market happenings without any hassles.
2. Detecting Bad Trades
The first duty of all forex traders is to protect their forex capital investment. Therefore, even when you suffer a few losses, your forex capital should remain significant enough to enable you to continue trading and possibly recoup your losses.
To achieve this, you have to learn how to detect bad trades early enough before your losses turn into huge, unmanageable amounts. For early detection, you can check on the following points:
i) Reversal Points
If the trade is placed too close to a likely reversal point, then it is potentially a bad trade.
If you have placed a long order at a resistance level, that is potentially a bad trade.
If you have placed a short order very close to a support level, that may be a bad trade.
iv) Reversal Candlesticks
If a short trade bears some bullish reversal candlesticks, you may potentially be in a bad trade. The same applies to long trades that show bearish reversal candlesticks.
v) Other Currency Pairs
If the currency you are trading in your preferred currency pair is moving in a certain pattern when in other currency pairs, you better take note. It will soon move in the same pattern in your currency pair.
So once you have noticed that you are in a losing trade, what do you do? You have to keep a cool head and turn to your forex trading strategy for guidance.
These are some of the points you should have in your strategy.
3. Actions to Take on Bad Trades
Once you have determined that you are on a bad trade with no chances of reversal, you should act fast and decisively to limit the extent of your losses.
There are various ways which forex traders use to exit trades.
Forex Exit Strategies
Most well organized forex traders have an exit strategy for every bad trade they find themselves in.
A common strategy is using the percentage retracement method. This means that if a trade goes to a 3% loss level compared to the total amount of your forex account, then it is time to exit.
Some of the exit methods include:
i) Limit Orders
A trader can instruct the broker to buy or sell a currency when it gets to a certain price. In this way, the trader avoids running into very high losses.
ii) Stop/Loss Orders
Bearing some similarities with a limit order, the stop/loss order is meant to limit the trader’s losses. The order is usually set at a certain percentage below the buying price of the currency.
iii) Trailing Stops
A trailing stop is a kind of stop loss order that shifts as your profits increase. You may set it to follow the price 10 pips behind so in case of a price movement reversal, you will automatically exit the trade only 10 pips behind your highest profit level.
4. Day Trading
Another way to limit your losses is by not holding overnight positions. You may set your trades to end each day just before the trading hours close.
This makes it easier to monitor your position and not be susceptible to surprise price movements that may occur overnight.
You have to always be objective when trading in the forex market. Keep a cool head and never attempt to recoup your profits immediately after a loss.
In fact, just close up shop for the day and come back another day when your mind is fresh and the painful memory of your loss is not strong enough to distract you from following your forex trading strategy to the latter.
Use this time off to assess and analyze the extent of your loss and its effect on your forex account.
6. Let Profits Accumulate
Limiting your losses is very important as it protects your forex account and investment.
But even more important is making profits from your investment. During those times that you are on a winning trade, be patient and allow the winning position to mature to a substantial gain.
Do not give in to the temptation to quickly close the trade to protect the gained profits. You may end up limiting what would have been a very profitable position.
A trailing stop is very effective in both riding a winning position and locking in profits while at the same time limiting losses.
Photo credit: Focusoft