Loss management

Protect your capital against a margin call

Trading on margin involves (great) risks of losing partially or totally your capital. So before being positioned into the market, one must know how to manage a losing position.

A trader will have 3 choices to protect and manage his capital :

- Trading with a StopLoss(SL). Experienced traders always use SL on their trades.

- Trading without a SL.

- Using hedging instead of a SL.

Let's discuss about the advantages and disavantages of these different approaches of handling a position, and some rules to get the full potential of these approaches.

1/ Trading with a SL

** Advantages **

Your capital is protected against big and unexpected moves against you. Add a TP and your order will be either winning or losing. You can go swimming and let the market decides.

As your capital is protected by your SL you can (and automatically will) use leverage.

** Disadvantages **

If your strategy doesn't fit the market your account will suffer losses after losses and finally a big drawdown. It"s a very hard task to recover such drawdowns.

The rules to use efficiently a SL are :

- A SL must be fixed at 2 or 3 percent of your capital, not more. Lower your capital will be, greater the difficulty to recover your initial balance will be.

- There must have as much as supports and resistances (S/R) between your open price and your stoploss. It means that your SL must be adapted to market volatility, not being constant.

If the market has a low volatility the S/R will be near your open price so your SL is small.

If the market has a high volatility the S/R are far from the price so your SL is large.

- One can use many tools to set the SL : S/R induced by prices, indicators like Moving Averages, draw horizontal lines and/or forks. In case of a long position the SL will be several pips under the price/indicator/lines and for a short position the SL will be several pips above the price/indicator/lines.

Here is a simple example to understand how a SL must be fixed. Look at this eurusd chart :

You have 10000$ in your account (standard account : 1 lot=10$/pip for eurusd).

You'll risk 2% of your account so 200$.

You have a signal to go short@1.2220. Your SL will be set @1.2250 on the MA. Thus there are 2 MA between your position and your SL : 2 resistances are between your entry price and your SL.

SLsize = SL-OpenPrice = 1.2250-1.2220 = 30 pips.

So the size of your position will be : risk / ( SLsize*pipvalue ) = 200 / (30*10) = 0.67 lots.

(NB : this result must be adjusted to the type of account and currency traded because the value will be different from 10).

Widen your SL and you will buy less lots/use less leverage.

Tighten your SL and you will buy more lots/use more leverage.

The risk will remain the same : 2% of your account.

A free Excel worksheet is available for free in the Download/Tools section.

2/ Trading without a SL

** Advantages **

You won't suffer any drawdown. No stress or few stress of hitting your SL. No stress or few stress because you won't use leverage at all. And your broker can't hunt your SL because you have none!

** Disadvantages **

If you enter inversely to a strong trending market you will end rapidly in some hundreds of pips loss. And keep this position for days, weeks or monthes if unlucky.... Rollover fees, margin used : it could be a bad situation. The only ways to exit are waiting for profit or cutting your tremendous losses!!

The rules to trade efficiently without a SL are :

- Use no leverage or a very very few. A strategy using leverage and no SL usually ends in a margin call.

- Never be against a very strong trend (some likes to call them "tsunami trend") or it will end up with a very big loss....

- Use SAR and/or divergences between prices and oscillators to detect market reversals.

3/ Hedging your losses

At last, instead of trading with or without a SL, you can easily use hedging to cover your losing positions. You can hedge your position with the same currency or with a correlated currency. But beware of drawbacks.

** Advantages **

Drawdowns are drastically reduced. Your broker can't hunt your SL. You equity is independent of the market moves. No or few margin is used when hedged.

** Disadvantages **

Hedging is usually used to maintain losing positions overnight, so on some currencies you can pay on your broker two negative rollovers. Hedging seems simple, but is for experienced traders, and you will see the real difficulty when it will be time to dehedge...

The rules to trade efficiently with hedged positions :

- Use few leverage to have enough margin for opening your hedge.

- Look for swap rates while making your hedging strategy : is it better to hedge with the same currency or another currency?

- If you hedge with another currency be aware of the correlation. It must be near 100%. If not adjust position sizes to get an equity independent of market moves.

- Hedging with the same currency is now forbidden in the U.S. It's allowed everywhere else.

C​onclusion

One can conclude that a position MUST always have a SL, unless you want to play loto. Playing loto on the forex is at best ordinary efficient and at worst leads to the loss of your capital....

There is no interest to hedge a losing position instead of taking your loss : you will have to manage one or two losing positions, and the problem of taking a loss will always be here when you will dehedge your positions.

Hedge can be used but must be part of an arbitrage/hedge strategy. Such strategies are difficult to trade as a professional, and even more difficult for a retail trader due to the spread.

So the best way is to set your SL accordingly with the market volatility, cut fastly your losses and let your profit run. That's how you will be profitable on the long run.