Building A Buffer

July 28, 2008 at 8:44 am Leave a comment

By FX Insights Moderator

Building A Buffer — Risk and Money Management Technique

In this commentary I’m going to explain the trade concept of building a buffer. This is a risk and money management technique that is unique to the FXI community and to our specific style of risk management. 

Building a buffer simply means adding profits to your account to protect your original balance/original account value (principle). For example, suppose you opened your account with $20K. Well, if you added a net gain of $2000 (10% ROI) that would mean you’ve added a buffer of $2000 against your original account value of $20K. 

Building a buffer is also valuable as you can use your buffer money as your usable margin money to take trades in the market while continuing to protect your original account value. 

There are two important things to focus on with this buffer building concept. The first is a risk management principle that is directly connected to usable margin. For the purpose of this commentary we’re going to use the $20,000 original account value/$2000 of buffer as our example… 

Now obviously the first step is actually building the buffer into your account which is done through your trading. During the buffer building phase of managing your account your trading style should be on the conservative side. From this point forward I’m going to explain how this all works based on my own style and the way that I do things and how I was trained to do it. You can take this information and develop your own game plan for how to build a buffer… this is just how I do it and what works best for me. 

Building Phase:

I get a brand new $20,000 account – totally fresh, never been traded. The only thing I’m focused on doing from the get go is building a buffer. That is my focus for the account… to protect the original account value with a buffer and then to build a buffer to use as margin. 

In the buffer building phase my typical entry size is anywhere from 0.5% to 1% — very conservative… and I will typically never have more than a total of 3% to 4% of the account’s total usable margin in the market at any one time.

My trading style is by far intraday. I will typically only take low-risk/high-reward trades and use very little margin doing so. I do not want to expose this new account to the higher volatility, higher risk times in the market like during London’s open, or during an NFP, or during any kind of big event with the Fed or ECB. If there’s a higher risk fundamental event happening in the market I will usually keep this new account unexposed to that during the buffer building phase. 

My buffer ROI goal is usually no less than 10%. That means I want to lock in 10% profit, so on a $20K account that means I would need to ad $2K in profit to complete the buffer building phase. My trading style and risk management cannot be altered under any circumstances until the buffer is built. 

And the goal is to have the account flat once I’ve achieved my buffer building goal. So, I lock in the $2K of profit and the account is flat – I’ve got 100% usable margin to work with and then I’m able to move on to the next phase of using buffer. 

Buffer as margin:

As far as the usable margin aspect is concerned, building a buffer of profit is critical because you can utilize your buffer to use as your margin. OK, so now I have $2K in buffer profits and I have all 100% of my margin to work with. I decide that I’m going to use my buffer money as my margin money – this means I’m willing to risk profits in the market and not risk principle – this is the key here. 

My risk and trade plan says that I’m going to make a 5% margin entry on my next trade. 5% sounds pretty high doesn’t it? Yes, 5% would be extremely high but I’m basing that 5% entry on my buffer money – I’m only risking profits, not principle. 

5% of $2K would be $100. This means on my account with 200:1 leverage I can take a 2 mini lot trade, which takes out $100 liquid cash and pays me $2 per pip.

Now if this trade goes against me my principle is still protected because I’m only risking profits on this trade, not the original account value. And should this trade really go against me and I’m forced to close it for a loss my loss is coming from my profits, not my principle. 

If I take a trade using buffer as margin and I’m forced to close that trade for a loss my next job is to re-build that buffer. It’s that simple. 

Daily buffer building:

Building a buffer isn’t just something you do with a new account, it’s something you can and should do everyday. There are two ways you can build daily buffer. The first is by opening and closing a trade and locking in those profits to pad your original account value. 

For example, suppose you locked in $100 worth of profits on a trade during the Tokyo session. Well, that means that you have $100 you can risk giving back to the market should your next trade(s) go against you and you have to close for a loss. Sure, it sucks giving profits back but at least you didn’t give anymore than the $100 you made on your last trade and it just puts you back to square one… 

The other aspect to building daily buffer is to take a trade and keep it open to provide a continual profit source to feed your equity and usable margin. Let me give you a real example of how this works… back on April 22nd the Team called euro shorts between 1.6000 and 1.6014. When we called those I had euro shorts at 1.5992, 1.5996, 1.6004, and 1.6011. 

As the market started dropping after it had reached that top, I closed all of those shorts except for one… I left my best euro short open which is the 1.6011 and it’s still open to this day. That killer short at 1.6011 is a perfect buffer trade that is feeding my equity and usable margin with positive cash flow every second the market is open. 

The point is this… if you get a killer trade, like a great short at the top or a great long at the bottom, leave it open to feed your account with positive cash flow, which will help protect your usable margin in the event you have several bad trades that go against you. 

So, let’s say you have a trade that is 500 pips to the positive and you have negative entries that total 400 pips to the negative. If you wanted to you could close your trade that’s up 500 pips and close your 400 pips worth of negative entries and you still come out 100 pips to the positive and your account is flat and you can start over again with minimal loss and a good frame of mind as opposed to taking a big hit and being gun-shy on your next trade. 

This matter of building a buffer and keeping a buffer in your account is key to the risk and money management aspect of trading the Forex market. It can save you from a margin call and it can help keep the market from screwing with your mind. 

If you have any questions on this technique please feel free to ask.

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