Some thoughts onusing technical market analysisto determinerisk management in forex trading.Perhapsthe greatest strength of technical analysis is that it allows traders to quantify precisely, 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. When the reasons for getting into a trading position are no longer valid, that position should be abandoned, usually at a loss.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 the line, the reasons for entering that tradewouldno longer bevalid. Therefore, the stop loss should be placedat some pre-determined pointdirectly underneath the line, where the break will have proven itself to be either false or premature. A failed breakout, as described above, 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 along position on a pullback to an uptrendsupport line, if on one of the subsequent pullbacks pricebreaks belowthat uptrend line by a significant amount, a good location for a stop loss would beat some pre-determined point directly belowthe trendline. A breakdown belowthe ascending trendline would mean that price is no longer pulling back and continuing the uptrend, but might perhaps be 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-lossbelow the line can potentially prevent a great deal of pain.
Risk management with the use of technical analysisis both logical and straightforward. By using technical analysis to help dictate stop losses, a forex trader is allowing the market to determine when to cut losses. This is much more reasonable than setting stop losses merely according to an arbitrary number of pips or some random point of pain.
- James Chen, CTA, CMT
* I will be key speaker at FXstreet.coms International Traders Conference in Barcelona, Spainin October2009 - for more information, please go to: www.traders-conference.com .
* For informationon my book, Essentials of Foreign Exchange Trading (Wiley), please click here.
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