1. No matter how complex things may seem, it still comes down to supply and demand.

The price of money is determined the same way that the price of anything else is determined; the law of supply and demand. Basically, if demand for something rises without a corresponding increase in the supply, its price will naturally rise. And if the supply of something shrinks while the demand stays constant or grows, its price will naturally go up. The trick in forex is understanding when the supply and demand equation will be rebalanced by the market. Here’s an example:

When Fed Chairman Bernanke announced on national television that the Fed was “electronically” printing dollars, it naturally meant that supply was increasing (or that the market was going to perceive that supply was increasing).  From that point forward (mid-March), the dollar depreciated against nearly all currencies until about the beginning of December.

Likewise, if and when the Fed announces its intention to begin draining the tremendous amount of reserves it created during the liquidity crisis, the market will perceive that supply is going to shrink and that will naturally cause the price of the dollar to rise.

Now, the type of movement I’m describing here is something you see on the daily charts over weeks and months and has nothing to do with the little bleeps and blips seen on miniscule time frames. In fact, the movement seen on 5, 15, 30 etc. minute charts has, for the most part, little to do with the law of supply and demand. For the most part, movement on these charts is driven by things like bank positioning, profit taking (or loss prevention of previous trades) by major players like hedge funds and investment banks, and the wiping out by big players of smaller player’s positions.

  1. Adjust position size according to where your stop must go.

If you wanted to sell something for say $10.00 and you knew there was a lot of demand at say $9.50, would you lower the price? Chances are that you would, especially if you saw a lot of orders clustered around $9.50 and few at $10.00. Of course, retail forex traders can’t see where orders are clustered (as banks can) but what we can see is where demand has been recently. So, wherever it is that demand has been seen not too long ago must be the place where your stop has to be placed. The simple rule is that you don’t want to be stopped out of a long trade where you have seen buyers recently in the market. Here’s an example:

Let’s say EUR/USD is currently 1.4275 and you want to go long. Let’s also say that you’ve seen demand (a.k.a. support) around 1.4200. You cannot get into this trade with a 25 pip stop because if you do, you leave yourself open to the possibility that banks will lower the price because they want to pick up additional orders at 1.4200.

Now, in order to hold this rather large stop, you’ll probably need to decrease the amount of lots you’re trading because a good rule of thumb is to not risk more than around 2% of your account on any one trade. In the above example, if 1 mini = a $1 position (assuming 100:1 leverage) and you have to risk $75 (which you have to do because you can’t allow yourself to get stopped out where you know demand is), you need to have at least $3750 in your account to take this trade with a maximum loss of around 2% of your account ($75/.02 = $3750). If you don’t have that amount in your account than just skip the trade.

Likewise, if you have say $6875 in your account than the maximum amount you should risk on this trade is $6875 x .02 or $137.50. In terms of lot size, $137.50/75 = 1.8 minis (rounded to 2 minis or a risk of 2.2%).

Of course, there’s another alternative which smart “shoppers” often look for. Why not try and wait for price to drop to the area where demand has been seen? At that point, you probably won’t need nearly as big a stop. Everyone wishes they could trade with the smart money so if the smart money is in the market at 1.4200, don’t you want to be in at that price too?

Look at it this way. You’re willing to make a bet that price will rise after you buy at 1.4275. Why not wait to buy where you know price has risen from before?