Tuesday, 22 May 2012

Money Management

A) Why Do Most Traders Lose Money?

The fact is that most traders, regardless of how intelligent and knowledgeable they may be about the markets, lose money. What could be the cause of this? Are the markets really so enigmatic that few can profit, or are there a series of common mistakes that befall many traders? The answer is the latter, and the good news is that the problem, while it can be emotionally and psychologically challenging, can be solved by using solid money management techniques.Most traders lose money simply because they do not understand or adhere to good money management practices.. Part of money management is essentially determining your risk before placing a trade. Without a sense of money management, many traders hold on to losing positions far too long, but take profits on winning positions prematurely. The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning trades than losing trades, but still loses money.

Money Management is the Key
Key Money Management Practices
So, what can traders do to ensure they have solid money management habits?
There are a few key guidelines that every trader, regardless of their strategy or what instrument they are trading, should keep in mind:
  • Risk-Reward Ratio. Traders should establish a risk-reward ratio for every trade they place. In other words, they should know much they are willing to lose, and how much they are seeking to gain. Generally, the risk-reward ratio should be 1:2, if not more. This means risk should equal no more than one-half of the potential reward. Having a solid risk-reward ratio can prevent traders from entering positions that ultimately are not worth the risk.
  • Stop Loss Orders. Traders should also employ stop-loss orders as a way of specifying the maximum loss they are willing to accept. By using stop-loss orders, traders can avoid the common scenario where they have many winning trades but a single loss large enough to eliminate any trace of profitability in the account.
B. Using Stop-Loss Orders to Manage Risk
Due to the importance of money management to long-term successful trading, the use of a stop-loss order is imperative for any trader who wishes to succeed in the currency market. The stop-loss order allows traders to specify the maximum loss they are willing to accept on any given trade. If the market reaches the rate the trader specifies in his/her stop-loss order, then the trade will be closed immediately. As a result, the use of stop-loss orders allows you to quantify your risk every time you enter a trade.

There are two parts to successfully using a stop-loss order: (1) initially placing the stop at a reasonable level and (2) trailing the stop – meaning moving it forward towards profitability – as the trade progresses in your favor.

Placing the Stop-Loss
Here are two recommended ways of placing and trailing a stop-loss order:
  • Two-Day Low. This technique involves placing your stop-loss order approximately 10 pips below the 2 day low of the pair. The idea behind this technique is that if the price breaks to new lows, the trader does not want to hold the position. For example, if the low on the EUR/USD’s most recent candle was 1.2900, and the previous candle’s low was 1.2800, then the stop should be placed around 1.2790 – 10 pips below the 2 day low – if a trader wishes to enter. As another day passes, the trader can raise the stop to 10 pips below the new two-day low.
  • Parabolic SAR. One type of volatility-based stop is the Parabolic SAR, an indicator that is found on many currency trading charting applications. Parabolic SAR is a volatility-based indicator that graphically displays a small dot at the point on the chart where the stop should be placed. Below is an example of a chart using Parabolic SAR.

C. EUR Overview
The European Monetary Union (EUR)
The European Union (EU) was developed as an institutional framework for the construction of a united Europe. The EU consists of 25 member countries; Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands, Portugal, Spain, Sweden, Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, and Slovenia and the United Kingdom. Twelve of these countries use the euro as a common currency. They are known as the European Monetary Union (EMU). Aside from a common currency, these countries also share a single monetary policy dictated by the European Central Bank or (ECB).

The EMU Today
The EMU is the world's second largest economic power, with GDP valued at over US$11Trl in 2003. With a highly developed fixed income, equity and futures market, the EMU is the second most attractive investment market for domestic and international investors. The EMU is primarily a service-oriented economy; services account for approximately 70% of GDP, while manufacturing, mining and utilities only account for 22% of GDP.

The EMU is both a trade and capital flow driven economy, and it has emerged as a legitimate competitor for the US in terms of capital investments. German bonds are a common alternative to US Treasuries. Unlike most major economies, the EMU does not have a large trade deficit or surplus. In fact, the EMU went from a small trade deficit in 2001 to a small trade surplus in 2002. EU exports comprise approximately 19% of world trade, while EU imports account for roughly 20% of total world imports. Because of the size of the EMU's trade with the rest of the world, it has significant power in the international trade arena. International clout is one of the primary goals in the formation of the EU, because it allows the individual countries to group as one entity and negotiate on an equal playing field with the US, who is their largest trading partner.

The Future of the EUR
The EU's growing role in international investment and trade has important implications for the role of the Euro as a reserve currency. It is important for countries to have a large reserve of currencies to reduce exchange risk and transaction costs. Traditionally, most international transactions involved the British Pound, the Japanese Yen, and/or the US Dollar. Before the establishment of the Euro, it was unreasonable to hold large amounts of every individual EU national currency. As a result, currency reserves were weighted heavily toward the dollar. At the end of the 1990s, approximately 65% of all world reserves were held in US dollars, but now with the introduction of the a single European currency, foreign reserve assets are shifting in favor of the euro. This trend is expected to continue, as the EU becomes one of the major trading partners for most countries around the world.

Economic Indicators for EUR
GDP for Germany, France, Italy
Germany has the largest economy in Europe, and German economic data moves the EUR price more than any other nation’s economic releases. French and Italian GDP is less important than German data, but it is still relevant to the EUR. GDP is the central measure of economic growth in a nation, and if the GDP of a given country exceeds or fails to meet expectations by a significant amount, currency markets often become volatile as a result. Because German data is more heavily weighted than French or Italian, a small difference between German expectations and releases would have the same effect as a much larger gap in French or Italian data.

Because of the political environment in Europe, unemployment data is an even more important indicator than it is in most other nations. Organized labor is politically more powerful in Europe than it is in the US, and Europe is much more sensitive to changes in employment. German, French, and Italian unemployment data can affect the level of the EUR, aside from having political implications as well. Unlike unemployment in the US, unemployment in Europe is an important indicator at all times.

Ten Year German Bund
German ten year bonds are the closest equivalent to the US 10 Year Treasury, and the difference in these 10 year rates can be an indication of where capital investments are likely to go as investors seek the highest return. This in turn will drive up the value of the currency in which the bonds are held.

Money Supply (M3)
One of the mandates of the ECB is to maintain low inflation, and one of the tools it uses to this end is control of the money supply. In order to maintain a target inflation rate of 2%, the ECB looks for an increase of roughly 4.5% in M3. If M3 is much higher than expected, it can be a sign that inflation is increasing and that a rate hike might be coming. Inflation is of much greater concern in Europe than it is in the US, and it usually comes much earlier in the economic cycle. This means that the ECB is more likely to aggressively raise interest rates than the FOMC, and the market may react to early signs of rate hikes.

Trading EUR
The Euro has emerged as a competitor to the dollar as a destination of foreign investment, and because the Eurozone is a major trading partner with many other countries, most crosses in EUR have high trading volume. EURUSD is the most heavily traded currency pair, while EURCHF and EURGBP have emerged as the dominant crosses for both CHF and the GBP.

  • Most heavily traded of all currency pairs, with the narrowest spread on the interbank market as buyers and sellers compete over the inside market.
  • Most active beginning 8:00 GMT (3 am EST) at the beginning of London trading hours. London is the dominant FX market in the world, especially for EUR, CHF and GBP pairs.
  • Often has little activity after the middle of the US session (roughly 1700 GMT).
  • Follows technical analysis extremely well, and is well suited to breakout or trend trades. The pair is poorly suited to range trades most of the time because of the large number of speculative traders.
  • Follows movement in capital markets: bond markets or equities, depending on which is most active at the time. When equities are experiencing a strong bull market, the S&P 500 can act as a leading indicator for USD strength against the Euro. When bond markets are dominant, the difference in yields on a 10 year German Bund and the US 10 year Treasury can identify movement of capital in the pair.
  • Open interest on the Euro Futures market on the Chicago Mercantile Exchange can be used as a rough indicator of market interest and positioning, although it is not a perfect volume indicator.
  • Reacts to data out of a variety of countries, sometimes focusing heavily on US releases, other times focusing on data out of Germany, France, and Italy. Because it trades more often in trends than in a range, indicators like moving averages or crossovers are more often useful than Bollinger bands or RSI.

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