Learn Forex – Using Technical Analysis to Manage Forex Risk
Learn Forex (FXpath.com) – When trading the forex market, risk management using technical analysis is both logical and straightforward. By using technical analysis to help dictate such risk management elements as stop losses, a forex trader is allowing the market’s price action to determine when to cut losses. This is much more reasonable than setting stop losses merely according to an arbitrarily determined number of pips or some random point of financial pain.Perhaps the greatest strength of technical analysis is not necessarily in determining trade entries, but instead that it allows traders to quantify as precisely as possible, and thereby help control, the risk factors inherent in trading. The most obvious risk control application of technical analysis is stop loss placement. Technical analysis employs a simple and elegant rationale for determining the location of stop losses. Clearly, when the reasons for getting into a trading position are no longer valid, that position should be abandoned, usually at a loss. The purpose of a stop loss, after all, is to cut losses while those losses are still manageable.
For example, in a breakout situation where a trade is entered on a price breakout above a certain resistance line, if price falls back significantly below that line after breakout, the reasons for entering that trade would no longer be valid. Therefore, the stop loss should be placed at some pre-determined point directly underneath the line, at which point the break will have proven itself to be either false or premature. A failed breakout is certainly a good reason to get out of a trade with a manageable loss.
Another example of risk management from a technical analysis perspective is as follows. For a trader who has entered a long position on a pullback to an uptrend support line, if on one of the subsequent pullbacks price breaks significantly below that uptrend line, a reasonable location for a stop loss would be at some pre-determined point directly below the trendline. A significant breakdown below the ascending trendline would mean that price is no longer pulling back and continuing the uptrend, but might perhaps be either consolidating or reversing its trend. If this is the case, the original reasons for getting into that trade (uptrend continuation) will have begun to be invalidated, and a properly placed stop-loss below the trendline can potentially prevent a great deal of pain.
Having market price action dictate stop losses, however, does not necessarily mean that a trader needs to vary his/her magnitude of risk on each trade. When using technical analysis to determine stop loss placement, the number of pips on a trade’s stop loss will necessarily differ from that of another trade. But because of the flexible position-sizing offered by the retail forex market, traders can adjust their position sizes to the number of pips on each stop-loss in order to achieve consistency in risk magnitude across trades.
In short, technical analysis affords forex traders a solid and straightforward methodology for managing downside risk. It is perhaps the most concrete and logical methodology for controlling risk on each and every trade.
James Chen, CTA, CMT (bio)
- Click here for my book, Essentials of Foreign Exchange Trading (Wiley).
- Click here for my book, Essentials of Technical Analysis for Financial Markets (Wiley).
- Click here for my video DVD set, High-Probability Trend Following in the Forex Market (FXstreet).
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Great post. Thanks James!