The ABCs of Trading the Financial Markets
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All traders, regardless of their experience or background, know that having a solid trading system as part of their arsenal is mandatory for potential success in the forex market. What I mean by solid trading system is one that has been tried and tested, with a proven track record of reaping profits while simultaneously minimizing losses. Furthermore, a robust trading system is one that is defined by trends; in other words, it’s a trend-following system. Since a trend is more likely to continue in the established direction, a trend-following approach is preferred to other types of systems. In these types of systems, entry and exit points of positions are defined by explicit rules.
Looking for the “Perfect” Entry
Traders who are just starting to get familiar with trading systems spend many hours discovering ideal entry points in the market. They search for the “Holy Grail” of entries, often getting disappointed and overwhelmed by the vast amount of technical tools which can be used to comb through all the possibilities. In reality, the goal for traders who follow trends should be to identify a trend in its infancy, before it develops into a full-blown trend. As soon as they develop this skill, they begin to acquire the necessary experience needed to instantly recognize trends- such as high-probability reversal patterns.
Examples of these types of patterns include Head and Shoulders, Double Top, Triple Top, Inverse Head and Shoulders, Double Bottom, and Triple Bottom – all of which can be recognized on price charts. On the subject of reversal patterns, it’s important to remember this prerequisite: a trader must first identify a prevailing trend before looking for a reversal. Beginners also fall into the frequent trap of looking for a reversal in a range.
Stop-Loss for Protection
Every serious trading system should be designed to protect a trader’s capital. One way of ensuring this is through stop-loss. An initial stop-loss, for example, is based on the relevant reversal that triggered the entry in the first place.
More specifically, an initial stop-loss placed at the top of a reversal pattern would be required for a short entry into the market.
On the other hand, an initial stop-loss would need to be placed at the bottom of the reversal formation for a long entry.
Ultimately, the most important purpose of stop-loss is to safeguard the trader from abrupt and unpredictable movements in price.
The concept of profit is what truly separates novice traders from the professionals. Beginners usually struggle to discover the perfect market entry, while the more experienced traders keep a closer eye on take-profit methods.
What undoubtedly reaps the greatest rewards, as far as take-profit techniques go, is a reversal in the opposite direction.
As soon as the reason of being in the market disappears, any remaining open positions are closed and potential profits are locked in. The trouble is that this set up is not frequent enough on the price chart to justify sole reliance on it. This technique also carries a big drawdown, which is another disadvantage. This, in turn, may have negative consequences on the trader’s psychology, which can be a recipe for disaster.
In terms of popular take-profit techniques, traders often choose the “trailing stop-loss” – which automatically adjusts according to the direction of the main trend during the market’s movement. With this method, potential profits may yield smaller amounts compared to closing the whole position at the reversal in the opposite direction, but there would be less drawdown too.
Similarly, setting predetermined take-profit levels and locking in profits as they are reached is another popular technique. Calculating predefined levels can be done in multiple ways, a popular one is using Fibonacci levels (1.618, 2.618 and 4.236). While this technique could reap smaller profit amounts compared to closing the whole position at the reversal in the opposite direction, it’s important to remember that they also ease drawdown, which is a big advantage for the trader’s psychology.
To trade the financial markets, one needs a solid trading system that relies on trend-following techniques and clear entry and exit strategies. Placing a protective stop-loss is vital for the safety of a trader’s capital, although beginners usually have a hard time accepting losses.
Take-profit is just as important as stop-loss when it comes to managing drawdown and not upsetting a trader’s psychological mind set, with the ultimate focus always remaining on getting more profits.
In today’s markets, which are prone to high levels of volatility and unpredictable movements of price, a robust trading system with a higher percentage of wins over losses is preferable even if the profits are smaller.
The ultimate goal for any trader is preserving capital – no matter what! Remember, the market will always be open for more trading opportunities tomorrow.
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Risk Warning: There is a high level of risk involved with trading leveraged products such as forex and CFDs. You should not risk more than you can afford to lose, it is possible that you may lose more than your initial investment. You should not trade unless you fully understand the true extent of your exposure to the risk of loss. When trading, you must always take into consideration your level of experience. If the risks involved seem unclear to you, please seek independent financial advice.