One of the biggest myths about trading, and what is usually stamped into the heads of traders from the very early stages of their careers, is that successful entry techniques will lead you to consistent profits. This is wrong! This and this alone is only one component, and there are unarguably many other factors which attribute to consistent success.
In most books and articles I have read about trading, the main focus of discussion is typically centered around entering trades. There are literally thousands of ways of doing it, as more and more indicators and trading strategies are developed over time. As we start trading, however, we learn that entering the trade can become rather easy once we have it practiced enough, and that managing a trade and knowing when to take profits becomes perhaps our biggest obstacle.
Trade management is perhaps one of the most overlooked yet vitally important aspects of trading. Any experienced portfolio manager will tell you that knowing when to call it quits and defining a systematic means of trade management is as important of the trade selection itself.
Poor trade management, just as with poor entry selection, can lead an otherwise profitable trader into an area of undesirable consequences if not executed properly. Here, we will outline the basic aspects of trade management: risk/reward, position sizing, taking profits and using stop losses.
Before we delve into any detailed discussions of the above, it is important to note that all three must be executed in terms of the market we are trading. In other words, they should be dynamic, or not a fixed pip amount. Many newer traders will define both a stop loss and profit target based on a fixed pip amount. This is generally an inefficient strategy because it completely ignores any dynamics of the market, and hinders their risk/reward ratio. The market does not “think” like we do, in terms of fixed numbers or profit goals, and instead reacts to key price areas, as we have outlined in previous articles. We are on it’s turf; its not on ours, so we have to shape our trading plan around its rules. Defining our trades around static numbers can be good if setting an ultimate limit on risk, but regardless, is not a recommended approach, especially in terms of taking profits.
One of the largest benefits of setting dynamic stop losses and take profits is the generous increase they can provide in terms of your risk/reward ratio. There have been many trades I have taken where I am only willing to risk appx. -25 pips and offered a payout of several hundred. My selection of a stop loss, in these cases, is based on a clear violation of a level I am expecting to be a sharp turning point for price. Any violation I would consider to be unexpected and not part of the overall trade plan. An example of this would be if I were to short EUR at 1.3000 resistance, and price broke through it, and then used 1.3000 as support. It’s a clear sign that price is likely to continue and I might look to exit if the price high is not valid resistance, as well. The combination of these two factors indicates strongly that price is going to continue heading upwards.