Risk Management
There are three basic questions that every trader should answer BEFORE entering a trade.
How much do I believe the market will move and where do I want to take my profit?
Limit Orders allow traders to exit the market at profit targets. If you
are short (sold) the system will only allow you to place a Limit Order
below the current market price because this is the profit zone.
Similarly, if you are long (bought) the system will only allow you to
place a limit order above the current market price. Limit orders help
create a disciplined trading methodology and enables traders to walk
away from the computer without constantly monitoring the market.
How much am I willing to lose before I exit the position?
A stop/Loss order allows traders to set an exit point for a losing trade. If you are short a currency pair the stop loss order should be placed above the current market price. If you are long the currency pair the stop loss order should be placed below the current market price. Stop/Loss orders help traders control risk by capping losses. Stop/Loss orders are counter-intuitive because you do not want them to be hit; however, you will be happy that you placed them! When logic dictates, you can control greed.
Where should I place my stop and limit orders?
As a general rule of thumb traders
should set Stop Orders closer to the opening price than limit orders.
If this rule is followed, a trader needs to be right less than 50% of
the time to be profitable. For example, a trader that uses a 30 pip
Stop/Loss and 100 pip limit orders needs only to be right 1/3 of the
time to make a profit. Where the trader places the stop and limit it
will depend on how risk-adverse he/she is. Stop/Loss orders should not
be so tight that normal market volatility knocks the position out.
Similarly, Limit Orders should reflect realistic expectation of gains
given the markets trading activity and the length of time one wants to
hold the position.