Hello traders! In my last newsletter, we discussed a couple of the basic rules of risk management for traders that included how to take profits when trading with or against the trend, and also how to limit your trades throughout the day or week. This week on how to use risk management to protect your capital and increase trading profits part two, we will add a couple of more rules to your trading plan. Let’s get started!
In every class that i teach, be it the seven day core strategy class i discuss the merits of using quality supply and demand zones to place our trades. We use ours odds enhancers, which essentially show how the charts are “shaped” to help us decide what zones are good enough to risk our money on in a trade. Some of these odds enhancers have been discussed in previous newsletters, but today we will discuss how to add some of your own (customized) to different forex symbols.
One extra odds enhancer that some traders use is the correlation between the pair you are considering trading, and the relationship to the US Dollar index. In the stock market, a possible odds enhancer is to trade stocks that “line up” with the market index that they are represented by. When trading a technology stock, very often traders will also check the relationship of the Nasdaq market to see if they are both trading into a supply or demand zone at the same time. When both your stock and your index are in a demand zone, the odds of your trade working out are greater. I’m sure most of you have heard the phrase “a rising tide lifts all boats?” The same thought applies here. If the stock market starts rising, most stocks (at least the ones with a high correlation to the market!) should rise as well. When trading certain currency pairs, some traders will use the US Dollar Index as an odds enhancer to certain currency pairs.
As you can see in this pair of charts, the EURUSD currency pair has a near perfect inverse relationship to the US Dollar Index. The current “score” over the past five months is approximately -0.93. (Correlations are more fully described in my newsletters, currency pair correlations part 1 and part 2.)
In this chart, the blue circles represent a turning point where the EURUSD made a swing low, while at the same time the US dollar index made a swing high. The pink circles represent where the EURUSD made a swing high and the index made a swing low. This is an obvious inverse correlation. A possible odds enhancer or risk management rule could be that you will only trade the EURUSD on the short side in a quality supply zone when the US Dollar is simultaneously in a quality demand zone. On the opposite side, only trade the EURUSD from the long side at a quality demand zone when the US Dollar index is in a quality supply zone. As stated in the previous newsletters, please make sure the correlation between the currency pair in question and the US Dollar index is a strong one! Adding this rule to a pair that completely ignores the index will certainly not help your trading. Yes, you can also use certain commodities (gold, oil, etc.) and their correlations as well. Let’s take another look.
In this AUDUSD and Gold futures chart, you can see that the charts themselves are somewhat correlated, at least to their turning points. I intentionally chose a pair of symbols that weren’t lining up perfectly, just to demonstrate that not everything does! From the blue circles both symbols had a strong move to the downside, and in the pink circles they both had a strong move to the upside. However, looking closely you can see that the up moves did not start on the same day. In fact, the AUDUSD started a strong move up several days prior to gold’s move. Remember our core strategy and how to use the correlations? When both symbols are in a quality demand zone (not marked), you can look to be a buyer. As both gold and the AUDUSD were in demand, the forex trader certainly could have gone long the AUDUSD.
So there you have it. How to use risk management to protect your capital and increase trading profits part two. Using the correlations as an odds enhancer to help manage risk in your trading plan can be a very useful tool. In my next newsletter, we will discuss even more ways to help limit and manage your trading risk.
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.