The purpose of this page is to start a series of tutorials on how to successfully trade the forex market – the PipHut way! They should help to shed more light on how I look to trade my signals and in general. As always, take it in and make it your own :).
This first tutorial will focus on money management – perhaps the most important piece of your forex trading and – too often – the one skipped by early traders.
Money Management
Money Management refers to – you guessed it – how well you manage your money! With me so far?
The focus of this page will revolve mostly around the risk/reward ratio aspect, though another important piece is the equity percent of your account you are working with. For example, a rule of thumb for equity is never bet more than 2% of your equity on a single trade. So, for example, if you have $10,000 in your account then you should not bet more than $200 or 20 pips on a single trade (or else get a a micro-account so you can wager 200 pips or $200). Too often new traders lose too much and then get increasingly desperate in their trades to attempt to “make up” the lost money.
Ok, enough about equity. As I said above this page is going to focus on the risk/reward ratio.
Risk/Reward Ratio
In short, the risk/reward ratio means the amount you are risking (i.e. your stop loss amount) against the amount you stand to gain (your profit or limit on the trade). So if you enter long on the GBP/USD at 2.0040 and you enter a stop-loss or determine you will manually close the trade at 2.0020 if it goes the wrong way then your risk is 20 pips per lot.
Pretty simple so far, right?
Okay, now if on the same deal you determine that your target, or where you will take profit and close the trade is at 2.0140 then your reward is 100 pips (2.0140-2.0040=.0100 or 100 pips). So on this particluar trade your risk/reward is 100 pips/20 pips or 5:1.
Risk/Reward Ratio Example
Before we get into what ratios mean to you and what ratios you should aim for, lets try another one. Take a look at the below trade signal and figure out what the risk/reward ratio is:
Short Entry: 1.5950
Stop-Loss: 1.6005
Limit: 1.5840
Take your time, figure it out… Ok, what did you get? Was it 2:1? If it was then you are right! Risk = 1.6005-1.5950 or 55 pips. Reward = 1.5950-1.5840 or 110 pips. 110:55=2:1.
Got it? Ok, if you don’t then read it a few more times, send me an email or post a comment below because this is very important. New traders too often do not set stop-losses and as a result may get a handful of 10, 20 or 30 pip gains (maybe even more) but then they get a 100 pip loss or worse because they keep hoping it will “just turn around” and it wipes out all of their gains plus some.
Now, here is where good risk/reward ratios become important.
Why is this important to me?
If you have a risk/reward ratio of 1:1 – meaning you risk the same amount as your reward each time – then obviously you have to win 50% of your trades to break even.
If you have a risk/reward ratio of 2:1 – or your target is twice as much as your risk every time – then you only need to win 33% of your trades to break even. Got that? You can lose 2 trades for every 1 you win and you will break even.
And it only gets better from there. Below are a few risk/reward ratios and the win percentage you need to break even:
1:1 – 50%
2:1 – 33%
3:1 – 25%
4:1 – 20%
5:1 – 17%
10:1 – 10%
Conclusion
A lot of new traders make the mistake of thinking “Ok I will just capture a few pips at a time, up to 10 or so” and they don’t even bother to put in stop-losses! What ends up happening is they may go on a streak for a few hours, maybe even a few days or more. But inevitably they get a big loss that wipes out all their profit and then some. When that happens you lose your confidence, your edge and you start to trade scared – and that only makes things worse.
The best traders I know practice good money management with good risk/reward ratios. Ratios of at least 2:1, up to 4:1. If you are a new trader I recommend you start with at least 3:1. The best traders sometimes don’t win 50% of their trades. But their wins are large enough where they make profit and then some.
Hi Mark,
In response to your money management comments, I would like to make the following comments.
In a stable market – consistent and set money management is of course along proven method to restrict losses and protect the account. Some might add to this and say maintain healthy profits.
What people don’t mention is the perils of a volatile and jumpy market conditions, and I find that the strict rule of the thumb risk/reward ratio, can actually go against you.
If for example you are trading 2:1 or even 4:1 per trade and you religiously stick to this whatever the outcome of any given trade – each loss reduces the account balance. Your next trade/s set at the same level are therefore 2:1 or 4:1 of a lower balance.
In a normal market one could agree or say that the winning trades will recover the previous losses, but the downside is the volatility.
When you see that your losing trades did actually come in and would not have been losing trades if you had set a higher stop losses for the same reward.
The point is that sometimes the market dictates this even, when by all analasys you entered the market in a good position. The problem being the market does it’s own thing before meeting your position. You could have calculated a good down trend and positioned a short in the right place according to your ananalsys. Under your Forex Signals heading you give a common example using support and resistance levels.
It is more common knowledge for example that the floor traders target Stop losses above and below support and resistant levels and very often I find my stops are met in these positions, expecially in a volatile market, despite the trade being right.
I am finding that in many cases, especially of late, it is more prudent to accept a lower reward and a higher risk, to profit in a trade that is positioned correctly in the normal expected move of the market.
The common solution to this by strict money management is don’t trade – as the trade violates your money management rules, but the problem with this is that 1) this only becomes apparent during the trade – as the market wasn’t expected to jump so high above resistance for example, before breaking back through to meet your trade.
The only other solution I can see is to increase your stops (risking more for the same reward) as and when the market demands this – so not to lose – what is actually a winning trade.
The downside of this is of course this affects your equity (restricting your trading potential on other pairs) – and if the market move continues unrespectable against you before coming in, you commonly believe that something odd is going on, question whether you had missed something like an adverse effect from news etc, and at this point, with uncertainty of where this is going, after frantically trying to review your original analyses – (no time for that now) – you inevitable close your position, losing more than you would have done, had you stuck to your money management R/W of let’s say 2:1 or 4:1.
I know that every trader has experienced this and I am interested to know your views and methods to you resolve such a position?
If I haven’t mentioned it before, may I take this opportunity to say I find your work remarkable and admire your commitment to take the time to help fellow traders along the way. This is a quality not genuinely found in many successful traders. I am sure many traders are indebted to you for your support and wish you all the more success for your dedication and efforts.
Kind regards
W.Chanson
Hello,
There is no risk in forex if we trade what we deposit, consequently no leverage and the withdraw should be any currency we convert.
In this manner our margin is safe.
Regards
Mark,
What is your view on hedging (why or why not)? For example, I’ve used a strategy to hedge a loss. Further example, if I got a buy and then the trend changed (due to news or whatever)and went against me @ -50 pips I would then enter a sell of equal lot size and take profits from the sell order (until it hit a strong support). However, I kept the lossing order until the price retracted fully or partially.
I don’t hedge, personally, because I only trade with the trend (so by default that means only one direction). Also with new NFA rules hedging in the US is a bit more difficult starting late November.
Yes, I have heard there will be some rule changes that will definitely effect hedging.
Thanks.
I think you can take your account out of US and do the hedging. Like most forex companies now provide a European account regulated by FSA where you can hedge