Order Of Magnitude » Forex

Forex Risk Management through Position Size

wdevauld — Fri, 22 Jan 2010 23:36:54 +0000

We regularly size our forex positions based on the amount of risk we are willing to assume. To detail a feel for the steps that are gone through for each trade, we're going to go through all the steps based on a hypothetical scenario. Our situation is a young, go-get-er that is managing a ¥1M account. Because this guy understands that he's young and can take on more risk (not to mention it makes our math easier), he is willing to lose 10% of his account on any one trade (which is not recommended, you should know your own risk levels).

The trader has been looking at the USD/CAD pair, over several timeframes.

USD/CAD - Jan 22, 2010

The trader feels that the recent short term rally is pushing into over-extended territory, and believes that the long term trend will once again assert itself and push the price back down to support around 1.025. Examining moving averages, trendlines and other forecasting tools, the trader settles on a short entry price of 1.062. If the price moves against him and pushes above 1.075 then the trader knows the gig is up, the long term trend has been broken and he should be out of the trade. The total loss the trader is willing to take is: 1.0750 - 1.0620 = 130 pips.

The USD/CAD pair has all of it's profit and loss calculated in Canadian dollars. So if the trader is going to risk 10% of his portfolio of ¥1M, first determine what ¥100k would be in Canadian dollars. CAD/JPY is about 85.25, so the maximum ¥100k loss would work out to be $1,173.02 Canadian. Now, what position size would result in 130 pips, being equal to the maximum drawdown of $1,173.02ish Canadian?

The position size would be: 1,173.02 / (1.0750 - 1.0620) = 90,232.31 CAD. Now, all transactions on the USD/CAD pair are done in the base currency, which in this case is USD. So converting the 90,232.31 into its US equivalent of 85,431.04. This means that if out Japanese investor wants to cap his risk at ¥100,000, then a short position of 85,000 USD/CAD entered at 1.062 and stopped out at 1.075 would put a ceiling on the losses with the price targets from the chart.

This simple example is missing a couple of larger points, like the exchange rate between JPY and CAD messing with the total profit and loss, as well as interest charged/rewarded for the currency position. This example also doesn't take into account any margin requirements, transaction fees, spread on the bid/ask or other risk factors.

Why would this Japanese trader enter this trade, if they were only planning on losing 10% of their account? Looking at recent bottoms in the chart, the trader has determined that a price target of 1.03 is where they would close the short position, which would equate to 320 pips of profit and more than double the 10% of their account that was at risk. Of course, the price can move in any direction, and every trader should do their own research.

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AUD/USD – Small Long Term

wdevauld — Mon, 21 Dec 2009 05:46:16 +0000

A longer term pattern that may turn into a head and shoulders reversal on the AUD/USD currency swap.

Head of 0.940 to a neckline of 0.895 is about a 450 pips measure giving a target of 0.850 A stop could be placed at 0.9320 where a breach of the shoulders would invalidate the pattern, and honestly we'd feel a whole lot better getting out at 0.920 where there was more recent highs made. Now on a closer timescale:

If price can get below and hold below 0.8840 then we'll enter a position so that a rise to 0.92 would at most deplete 10% of risk able capital. Every standard lot of $100k you move, a pip will cost $10, so a move to our stops would cost $3600. Remember to do your own research.

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Looking at AUD.USD ahead of RBA’s GDP numbers

wdevauld — Tue, 15 Dec 2009 19:59:30 +0000

We've been in and out of several positions on AUD/USD in the past couple of weeks. We slightly ahead in trading with a few excellent positions balancing out a few more that stopped out. Tonight the Reserve Bank of Australia is releasing its GDP numbers, and as a result we're analyzing recent price action to determine what plays, if any, we would like to make

On a longer term timeframe, the 55 day moving average is rising, and is recently above current trading at around 0.9133. The rising long term daily average points us towards only entering on the bullish side if an opportunity presents itself

There is also a loose symmetric triangle forming starting around the beginning of November. The triangle points to a price tightening inward towards 0.9125, which is close to the SMA(55) on the daily. We believe this tightening is foreshadowing an upcoming price move.

For a longer term trade, the recent lows around 0.8905 (Nov 2nd) and 0.8946 (Nov 27th) are important when determining a stop. Since we'd like to take advantage of the difference in interest rates, a longer term trade is in our favour, which leads us towards a 0.89 area for a stop to allow for more volatility. Allowing for more volatility will most likely result in a longer term trade where we can collect the interest difference.

Resistance has shown itself in the 0.9320-ish area a few times with highs at 0.9328 (Oct 21st), 0.9322 (Nov 25th) and 0.9323 (Dec 3rd)

Tightening in to hourly bars, it becomes apparent that the area around 0.9175 has been a source of resistance frequently in the last 2 weeks

Our plan is to watch smaller timeframes (hourly and 10 minute) if the price action moves towards 0.91. We will not purchase higher than 0.9125 and will maintain a 0.89 stop. This equates to 225 pips of risk worst case. We will calculate the position size so that this maximum loss will equate to no more than 10% of our available capital (Rule #1). If we maintain an exit at 0.9320, we are looking at 195 pips of profit. This 1.15 Risk to Reward does not meet our requirements for a solid trade.

If we decide to tinker and adjust the upward price target to the October high of 0.9406 (changes Risk/Reward to 0.8) , or move up our stop to the 0.9020 (changes Risk/Reward to 0.53) level we are just trying to justify a trade that was objectively thrown out. That said, the GDP news is a large chunk of fundamental information and if the real numbers beat the consensus estimates of 0.4, and the market starts to significantly move showing that the information is not yet priced in, we may entertain the higher stop of 0.9020 if the strength of the hourly timeframe is significant. Otherwise, we'll let this one pass.

[UPDATE: RBA's GDP disappointed @ 0.2 as opposed to a 0.4 expected value. The pair immediately shed 50 pips in 2 minutes while we were on the sideline]

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Tuesday Night Commission Gathering

wdevauld — Wed, 28 Jan 2009 06:44:09 +0000

We feel that Interactive Brokers are hards down the best brokerage you can use as a personal investor in Canada. Their a la carte approach to trading, news and data is appealing to those who count their dollars and cents. Recently, however, because our entry targets have not been reached, we have been sitting on a lot of cash and not entering a lot of positions. For those using IB in Canada, you can get your data and news covered, if you generate their cost in commissions. Since we love our data fees, in January we came up almost $200 short, and had to pay out of pocket for data and news. Not something that happens very often, and not something that we would like to repeat

As a result, we take a small portion of our holdings at IB, and put them to work in the currency markets. We have never been successful at long term trading the currency markets, but short term, we can usually turn a small profit, or break even. This is great, as a few hours of trading currency swaps can generate enough commission charges to pay our whole month of services.

Since the Fed is going to do something to the markets tomorrow, and the majority of participants are likely to get hurt, we decided to spend tonight trying to pull in a small profit on the Forex market. The usual setup, is to drill down from long term to short term and determine price targets and ranges. Most nights, after the preparation is done, the remainder of the evening is waiting for price to bounce off, or cross any of the targets that have been set. Tonight was different, and instead of having to spend the evening waiting for something to happen, a lot of price targets were hit immediately. We thought we'd share what we usually stare at while we are trading currency, here's a shot:

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Covered Call: PLD

wdevauld — Mon, 12 Jan 2009 08:21:28 +0000

The third week of the month is usually crazy, when short term pressures overwhelm logic and reason. Our weekly scan produced an interesting gem: ProLogis. Being as options expire this week, we found the bid/ask spread for the in-the-money $12.50 calls to be a bit out of the ordinary. Examining the Equivolume:

It would appear that this REIT has been going for a bit of a run and big volume appears on the right kind of days.

Now for the 50-50. We have an upward moving stock, that is due for a pullback, and in 5 trading days the options expire. PLD has a 15 trading session average true range of $1.75, which is pretty large for a stock holding the Friday's end of day price of: $14.12. Yes, 12% of current trading price.

Now, if a covered call position could be entered under these conditions, you would lay out $1412 for 100 PLD shares, and then sell a single covered call at $12.50 strike for $2.50 a share, or $250 total. If the price falls below the strike in the next 5 days, your cost basis is $10/share to offload, so we'll have a still profitable stop at $11.75 to exit the position. If the equity remains above $12.50 until Friday, you'll get called away, along with all the fees that produces. The only thing you get to take home is the premium.

So let's say your broker lets has a $10/transaction fee (hopefully you can do better). Your initial outlay is $1412 (equity) + $10 (commision) - $250 (option premium) + $10 (another commision) = $1182 (total expenses). You get called away, so you sell your stock for $1250 (minus $10 again, that broker!), and take home $1240. That mean $68 dollars in your pocket, after fees, on an outlay of cash equal to $1182 (you'll lose way more in buying power) in 5 days, if the shares stay above $12.50. If they go under, get out, and keep whatever premium erosion you have accumulated at that point. So on the upside you can get 5.7% on your money in 5 days, and there is safety net down to $10 before you start to lose money.

If your greedy, or want to take on more risk. The February call options have high volatility priced in. Have a look at our premium chart:

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Long Here on EURUSD

wdevauld — Tue, 22 Jul 2008 03:12:19 +0000

Over the last couple of hours buying pressure on EURUSD has been increasing against 1.5935 resistance. Depending on how you read your patterns, you could put in a 40pip profit target, considering the height of the triangle:

We're not quite that aggressive, and we also hate missing out on a good run. Offloading half the position 20 pips above resistance at 1.5955, alows us to set a stop a few pips above our entry to ensure that we don't loose anything on the posistion once it has become a winner. The initial stop should ensure a 2:1 reward to risk ratio. 10 pips of risk to the downside at 1.5915 will invalidate the uptrend, so you could even place your stop just under the local minimum @ 1.5919 to tighten up the amount at risk.

The battle won't be an easy one because 1.5940 could stop this upward trend in it's tracks, and after that we need to break the highs set on the 16th @ 1.5948. After that we can't find resistance until 1.5880 which is a nice 5 pips above where we take profits at four times our risk.

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EUR/USD Stopped Out

wdevauld — Wed, 16 Jul 2008 17:22:02 +0000

Despite all our good intentions, our trade between the Euro and Greenback was stopped out. The price action could not penetrade 1.5920, and reversed. While the moon was high in the sky, and we were walking around dreamland, the price did manage to poke above the 1.5920 range for a few hours. Then as it tested 1.5950, the price was hammered down over hundred pips in 4 short hours. I'm sure someone has a strategy to trade this currency with its recent price movements, but we're going to be staying out of any large posistions.

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Where is EUR/USD Going?

wdevauld — Wed, 16 Jul 2008 01:22:32 +0000

If you take a look at the daily chart for EUR/USD, you can see the pair has been trading between 1.53 and 1.60 since April. No trend has really shown itself, as the price has failed to establish a pattern of direction in its highs and lows. The price has been running up since mid-June, and is now trading very close to all time highs. We could have a breakout if the price is able to break and hold above the 1.61 level. Zooming in on a tighter timeframe:

30 - minute EUR/USD

Over the last couple of days the price has moved in an upward trend, pushing to higher highs and holding at higher lows. Recently a new high of 1.6039 was established, before the price was forced back down below 1.6. Now, a new low has been established and the price is turning up.

For the breakout, if the price moves into or above the 1.604 - 1.605 range and is not forced back, the EUR/USD could push a distance into uncharted territory. The heavily psychological 1.6 barrier would be broken, and the breakout trader would love to see the same sort of price action that happened when 1.50 fell. Of course, the resistance could hold, and push the price back down to the 1.56 levels, or perhaps all the way back down to 1.53. You have to wait for the pattern to form, else you could get burned.

For the trend, getting in now while the price fights with 1.5920 may be a good idea. Unloading at around 1.6020, which the price action has seen recently, would yield 100 pips of profit. Limiting our losses to 50 pips with a stop in the 1.5870 area would be just above recent lows.

Because of these reasons, I'm currenly long the EUR/USD pair, and looking to unload the trend trade around the all time high to seal in some profits. I plan to get back in if the rocket looks set to blast off with price remaining above 1.6

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Gross Net

wdevauld — Tue, 15 Jul 2008 04:27:07 +0000

Tried to profit off of movements of the Greenback using Euros, Loonies and Yen. My own currency kicked me in the teeth a couple times, and good risk management stopped the bleeding before it got too bad. Through out the session I managed to squeek out a small gross profit and loss.

What makes it so gross is that it was eaten by the $224.28 in commissions and fees. The bright side is I know I'm good for enough trades to keep my news service free. For the day, however, I was down more than a whole case of beer. Having slimmer fees, it is very easy to get tempted by every twitch in the price action. I'm shifting gears and shorting USD/CAD and going long EUR/USD looking at taking profit towards the extreme levels below parity and above 1.6

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