Handling Divergence Drawdown
One of the biggest challenges that FOREX investors face when utilizing the divergence strategy is drawdown. Drawdown occurs when a number of stops are triggered at various points in a trading cycle. When a sudden number of stops are hit, the price may automatically tank, thereby leaving investors short of profit. In fact, sudden drawdown may trigger further stops.
This is why it’s very common to find sudden dips in price. It’s not so much that there has been a sudden shift in investor psyche; the fact is that when a number of stops are triggered all at once, the market automatically reacts. When the price dips and further stops are triggered, it can be hard to make a profit.
Unfortunately, some investors find that their positions are liquidated even before they get into take-profit territory. All of this is due to the fact that stops are triggered automatically.
Now, here is a common mistake that investors make: they decide to avoid setting up automatic stop-loss points in order to avoid being liquidated in a drawdown. This is a dangerous situation, to say the least. There is no doubt that you are playing with fire. It could be that the action gets hot and heavy, really fast. As such, you may not have enough time to react. This is why you cannot expect your human reflexes to react faster than a computer.
It’s also important to note that divergence trading is not an exact science. Because of the fact that stops can suddenly be triggered all at once, you have to be aware that it is by no means a perfect strategy. This is why setting up your deal in the right manner will help you avoid getting knocked out of the game even before you have a chance to make a profit.
It should also be noted that you need to ensure to keep your instincts in check. If you choose to set up your take-profit points to high, you may not have a chance to get that high. As a result, you’ll be knocked out by sudden drawdowns.
Now, there is one other thing to watch out for: if you get in at the bottom of the trend, it means that your stop-loss point will be much lower than that of an investor who got in after you did. As a result, managing an adequate risk to reward ratio will help you manage drawdowns much easier.
Consider this situation:
You got it right at the bottom of the trend, right before it reversed. As such, your position is now 1. You decided to set up your stop at 20 pips. This would set your stop-loss 0.80 while you are using a risk to reward ratio of 2:1. Consequently, you set your take-profit mark will be 1.40 (20 pips * 2 – this is the 2:1 ratio).
Under this setup, let’s assume that the price hits 1.41, then your position will be liquidated as you hit your automatic take-profit mark. This means a successful trade. You make money, and all is good. However, let’s assume that you are feeling b0ld. You set up a 3:1 risk to reward ratio. This puts your take-profit point at 1.60. However, as investors get in later, they set up their stops at around 1.45. A sudden dip in the price at around 1.47 causes prices to dip below 1.45. This automatically triggers a bunch of stops. A number of positions are liquidated, and the price does not make it past 1.40. Yet, you are stuck with a take-profit point of 1.60.
Do you see why you may never hit your take-profit point if you set it too high?
This is why savvy investors know that it’s best to set up trades that are realistic. If the price of the currency pairing seems to be trending at a maximum of 1.50, for instance, then you might be better off setting up your take profit point somewhere below this range. This will ensure that you avoid setting up your expectations too high, thereby running the risk of leaving you out in the cold.