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How To Measure Risk With A Trendline

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How To Measure Risk With A Trendline

Postby johnsmith00710 » Thu Jun 27, 2013 6:55 am

Professional traders first manage the risk in any trade and only then think of take profit. On the other hand, new traders or what you may call inexperienced traders first think of taking profit and later on try to manage risk. You should make it as a rule that the most important thing in trading is risk management. First manage the risk in any trade and only then think about taking profit. If you can use this rule consistently with discipline, overtime, you will find that the number of your winning trades will increase and your profits will start compounding into a big figure.

The most important thing in risk management is the placement of the stop loss order. Risk is measured with the number of pips that you are wiling to lose in a trade. It can vary from trader to trader depending on their personality and nature. For an aggressive trader, 100 pips stop loss may be OK but for a cautious trader, this maybe too much. So, how do you measure risk so that you know this much loss should be acceptable?

The most important rule in determining the placement of a stop loss should the reason of getting into a trade. What his means is that when the technical reason for getting into a trade or into a position no longer exits or is no longer valid, the trade should be closed or abandoned even if it is at a loss. After all what is the purpose of a stop loss? To cut your losses while they are still manageable.

For example, you are expecting a breakout on the upside at a certain price level. Where should you place the stop loss? Obviously, if the breakout did not take place as expected and the price fell below that price level, you would not want to be in the trade. So, the best place for placing the stop loss is right below the price level where you expect the breakout to take place.

So, in case of a false breakout, if the price level later on retraces itself, you are no longer in the trade when the stop loss is hit. Let's take another example. Suppose, you are trading a downtrend. Where do you enter the trade? Naturally you would like to enter the trade when the price action hits the resistance by going short. Draw the trendline. Wait for the pullback and enter the trade when the resistance is hit.

The stop loss should be placed right above the trendline so that in case the pullback continues and the price action breaks the trendline, you are no longer in the trade. After, you wanted to trade a downtrend. A break above the trendline is an indication that the resistance has been broken and the downtrend may not longer be valid.

Similarly, in an uptrend, you would want to enter the trade when the support is hit. So, you will go long when the support is hit and the stop loss should be placed right underneath the trendline. This way, if the support is broken, you are immediately taken out of the trade.

Correct placement of the stop loss is essential to avoid pain in trading. Technical analysis and trendlines should be an important component of your risk management strategy. Many traders make the mistake of taking risk management lightly. As a trader, the most important thing for you is risk management. Master it first,if you want to become a winning forex trader in the long run!
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