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 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.
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
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%
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.