Over time in your trading, there will be many trades that you miss – meaning that price has already left a good level to enter your position. This is an inevitable fact in trading! We can’t possible see or take every trade that exists. We have covered what constitutes a good level of supply and demand, so you should be well aware of what constitutes a good level, and that we prefer to take trades in these levels. But entering the trade is only one-third of the equation as a trader. We also have to be aware of where our stop loss and profit target must go. In fact, we must know all three parts of the trade before we enter the trade! This is a very common mistake that new traders make – that is, entering a trade without having the entire trade planned out ahead of time.
So where do your stop loss and profit targets go? The very basics are that (in a long trade) your stop loss goes below the demand zone that you used to enter the trade, and your profit target is just under the previous supply level you are targeting. On the short side your stop loss goes above the supply level you are using to enter the trade, and profit target is slightly above the demand zone you are targeting. The main reason we put our profit targets just a little before these levels is that we want to get out ahead of the other traders using the same level. I call it being “smart greedy.” All of us are just a little bit greedy, which isn’t a bad thing. Being “dumb greedy” is a bad thing! Dumb greedy is where you try to exit the trade at the very top in a long trade, or the very bottom in a short trade. The only traders who can exit at these locations are the lucky ones, and luck doesn’t last long! So we want to take our profits ahead of the majority of traders-be smart greedy.
In the following USDCAD chart, I’ve highlighted a supply level to go short, and a demand level for a profit target. One of the great things about trading from a 60 minute chart like this, is that you are able to see the levels well in advance of price reaching them – making creating your trade plan nice and casual. No need to frantically study the charts when you have hours to place your orders!
I’ve marked with numbers the locations that some traders entered this USDCAD short trade. Number 1, the first test of this fresh supply level, gives the trader the best reward to risk ratio – about a 3 to 1. Another potential entry was near number 2. As you can see, I’ve only placed one line for the stop loss and one for the profit target. The closer you can enter to the stop, the smaller the risk and greater the reward in the trade. Taking the trade at number 2 gave you a slightly larger stop, and thereby a smaller reward.
What about the traders who took the short at number 3? Obviously, you could have placed your stop above the small swing high, but the best stop location is still where it is marked on the chart. This reward to risk would have then been about 1 to 1, not recommended. How about at number 4? This is by definition chasing the trade! The reward to risk would have been about 1 to 3, completely backwards!
If you notice, the stop loss and profit target are in the same spot for whichever entry you took. The main point is the market doesn’t care where your entry is – only you do. When your stop and profit targets are placed correctly, the market will often respect those levels. By taking the better entries, waiting for the good trades to come to you instead of chasing the pair, your reward to risk ratio will always be much better. Another way to look at this is that we don’t trade in the middle of a range, only near the extremes. If you find the price action in the middle of the range, you must wait! Too often new traders will take trades in the middle, and the natural market volatility will often stop them out. I’m sure this has happened to at least a few of you!
So the lesson is this: be selective in your trades by patiently waiting until the currency pair gets to one of your extreme supply or demand zones. When you do this you will take fewer trades, they will be higher quality trades, and you also will probably have more time for the rest of the things you enjoy doing!
Written by Rick Wright, Online Trading Academy Instructor. Rick Wright’s goal as an Online Trading Academy Instructor is to accelerate the student’s learning curve, whether they are interested in High Frequency Trading or Investing for Beginners. He teaches classes on Online Stock Trading, Forex Trading and Futures, among others. Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business. Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.