Analysing, anticipating and planning

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Making a forex trade can be extremely risky and, like doing anything that takes risk, you can take precautions to minimise its impact. In forex, there are three skills you can develop to help you manage your trading risk: anticipating, planning and analysing.

Anticipating: How do I handle risk?

It's important to realise that even the best forex traders have losing trades. While you may make some very successful forex trades, you will also make some losing trades. Fortunately, there are a number of things you can do to anticipate risk...

1. Protect your position with stops, limits and other order types

There are a number of order types, such as trailing stops, Parent and Contingent (P&C) and Order Cancels Order (OCO) designed to help traders manage risk and protect potential profits.

2. Set proper levels

You might say that setting a stop is an art; you need to make sure that your stop is set so that your trade can handle smaller jumps and drops in price while protecting you from losing your shirt if the market doesn't go your way.

A stop that's too narrow may lead you to re-enter the market, causing you to get stopped out again. That can cause more damage to your account balance than if you entered a stop that was too wide or no stop at all.

3. Check your emotions

Sometimes, the factor that determines how successful your trade will be isn't the amount of research you did, but your mindset at the time.

4. Create a trading plan and stick to it

A good trading plan is crucial to your trading success. Not only will it help you meet some of your goals, it will define the way you trade, what you're willing to risk and how you will protect yourself when a trade doesn't go your way.

Planning: How do I create a trading plan?

A trading plan serves as a steady anchor in chaotic markets, helping you forecast when to enter and exit the market. Best of all, it's fairly easy to create. The following steps may help you get started.

1. When constructing a trading plan, ask yourself:

A Will I trade only one specific currency pair or many?

B Will I trade on a daily basis or hold my positions for days or longer?

C How much do I want to make?

D How much am I willing to lose per trade?

E If I trade on a daily basis, how many consecutive losses will I tolerate before I stop for the day?

F How will I analyse the markets? Will I look at news and other events? Will I examine charts and price movements?

G How will I use stops to control my risk?

H Will I have one profit target or multiple targets?

I What kind of profit can I reasonably expect to gain?

2. Using your answers write out a short, but detailed plan of action.

3. Stick to your plan.

Keep a diary of every one of your trades; this will force you to follow your rules and avoid impulsive trading as much as possible.

Analysing: How should I analyse the markets?

You've developed your trading plan, but how are you going to analyse the markets?

One of the most common ways is through the use of price charts, which plot the recent prices of a currency pair on a graph and provide a snapshot of market movements over a particular period of time.

Line charts are one of three common chart types that most traders use. They provide a quick way to view the changes in price movements over a period of time.

Also popular are bar and candlestick charts, which provide an easy-to-analyse appearance that displays detailed information about the price movements of a currency pair.

Each bar or candle on the chart is defined by four price points (high, low, open and close). The length of the bar or candle represents the level of trading activity for a specified period. For example, on a chart with a 10-minute timescale, a bar or candle would represent all of the trading activity on the market in a ten-minute period. When the price of a currency pair rises, the bar or candle appears one color (usually green) and when the price of a currency pair drops, the bar or candle appears another (usually red).

Most traders switch between different time frames so that they can compare market movements and verify trends.

Analysing: What is technical analysis?

If you're familiar with trading other financial products, you know that traders tend to hold on to their positions for as long as the market moves their way. When they lose confidence in the market, they usually reverse their positions quickly.

Technical analysis is the study of repeating patterns and movements in the market caused by the pattern-like behavior of traders. Traders use technical analysis to monitor the current and historical price movements of a currency pair, help determine market trends and forecast potential entry and exit points for their trades.

For more on technical analysis, visit the Interactive Investor Knowledge Centre.

Analysing: What is fundamental analysis?

Fundamental analysis traders track political, social and economic forces and then forecast whether the value of a currency will go up or down.

Many new traders will develop their fundamental analysis skills by following news events and scheduled economic announcements. But there will be times when the price movements of a currency pair won't behave as you believe it should based on your fundamental analysis.

That's when it becomes important to incorporate technical analysis into your strategy as well.

As you begin to follow economic announcements, you may understand why some events - like the consumer price index - may cause markets to move.

But you may wonder why it's important to follow lesser events, like the food price index. Usually, a major event provides an indication of the state of the economy. But traders follow lesser events because they provide an indication of upcoming major announcements. For example, a jump in food prices may mean the consumer price index will jump as well.

Get more on fundamental analysis from the Interactive Investor Knowledge Centre.