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.
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.
November 19, 2008 at 09:31
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
March 13, 2009 at 08:40
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
November 13, 2009 at 20:11
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.
November 13, 2009 at 20:14
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.
November 13, 2009 at 20:38
Yes, I have heard there will be some rule changes that will definitely effect hedging.
Thanks.
November 15, 2009 at 12:16
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
June 12, 2010 at 04:12
Mark,
Thanks for your advised in money management. I am new in forex market, i will take your advise in doing so. You are correct, before reading your articles, i didn’t set a stop loss,and it is true i only get 10 or 20 pips because of afraid of losses. After reading your money management, at least i know since i know nothing about forex, i should take whatever advise given by expert. Off course, now i understand why i should set such ratio for risk/reward! Mark, thanks again.
June 12, 2010 at 08:17
Forex currency trading has become more volitile like mentioned above. I use now half of what I wanted to speculate with for my first trade, if my prediction is right, then usually I am right up to the end of my prediction, currently Mark,s prediction. But then, when I am conviced me and Mark was right, I ad another trade and make the second trade’s stop loss tiny. A gambler starts doubling his bettings when he is loosing, I double mine when I am winning. Makes a vast difference at the and of the day.
June 17, 2010 at 17:20
Thanks for your advised in money management. I am new in forex market, i will take your advise in doing so. You are correct, before reading your articles, i didn’t set a stop loss,and it is true i only get 10 or 20 pips because of afraid of losses. After reading your money management, at least i know since i know nothing about forex, i should take whatever advise given by expert. Off course, now i understand why i should set such ratio for risk/reward! Mark, thanks again.
June 23, 2010 at 14:35
Maybe these chart might help to control your Money Management. By using 2% of risk and stop loss of 40 pips. Take profit depends on you..10pips, 20pips, 30pips…..Using standard accounts..
2% (40 PIPS STOP LOSS)
> $900 to $1k ——> 0.04 lot
> $1k to $2k ——> 0.05 lot
> $2k to $3k ——> 0.10 lot
> $3k to $4k ——> 0.15 lot
> $4k to $5k ——> 0.20 lot
and so on….
July 3, 2010 at 11:21
@piphut. thanks mark for ur advise. think i the meaning u attached to stop loss– how well u manage ur money. am a new trader and av been so indscipline in using stop loss order noy untill av suffered much nd discover that one a price action breaks a resistance/support level, it may not pullbak to that level in the short term and may as well contine to trade upward and if care is not taken, ur equity may not be able to sustain the upward/downward move—- this is my own psychology about trading now and the reason its so important to always know how much u are willing to looses before placing any trade. however, mark, pleae i av this questions that i’ll appreciate answer from u or anyone on this website.
1. since the primary trend is the trading idea for the day according to ur daily signal, which means the secondary trend also occur (at least atimes) but i’m always confused as to when to enter for the secondary trend especially in the morning session when the european session is about opening. please trow more light on this area for me. kos i misssd out o thursday move eventho i was initially long on EU/USD but for for fear factor i pulled out then enter immediately your signal level was hit oping the primary trend has begin, altho thursady move is very rare in my own view as well. i wasnt hit that bad anyway but i missed the oportunity on that upward movement.
2. i discover that its very dfficult to get a precise S/R level especially looking at the difrent oes given by the variuos websites and profesionals but since i joined this website, i think urs is more precise and accurate. my discovery is that there tends some little devition of 10, 5,8, pips difference–why and can one get a precise S/R level and again as a discovery also, i discover that previous resistance/support level sometimes respond to any move, so can that be consider as trader action zone ( where to short or long) please expantiate further.
August 2, 2010 at 14:02
I am new to forex trading. I try to read most info i can find on forex trading, your site by far has shed light on what i have to consider before and when trading. I receive your daiy trading advise and found it to be more/relativley accurate.The information on risk and reward is definitly valueble as i understand it now. I endevour to apply this in my trading and focus on the 7 trading strategies/considerations you gave.
September 5, 2010 at 13:30
We started to a software as Bayilik Franchise Software. This infos gave help us for improve our software. We will send our software for your recommend.
September 9, 2010 at 10:09
Hi mark. What is hedging and how to use it.
December 11, 2010 at 11:49
thanks mark,ur site has bn so helpful 2 me as a beginner in forex trade.pls i nid more light on wat hedging is all about and how it works.more blessing.once again thanks
October 5, 2010 at 08:38
I trade with the trend on EU, GU & GJ. This pairs and the forex market is one of the most trendy market around.
On a particular time frame(1HR, 4HR & Daily) when the market is producing higher highs and higher lows–> uptrend, i go long. While lower highs & lower lows,–> downtrend, am shorting. I use a minimum R:R of 2:1 and trail the stop. My default stoploss is 50 pips on the 1HR TF.
Thanks to Mr. Jacko (House of pleasure and pain) i dont hedge but when my stoploss is hit, i allow the market to go by 30 to 50pips in the other direction, before entering a new pending order at the same price that the market took me out. If i was long, i will enter another long order( buystop) and if short- sell stop. Except for trend reversal, most often than not, the market eventually turns back and since you are now on its path, it picks you in right were it took you out, you recover what you lost and some handful of pips. It works, try it out.
December 22, 2010 at 22:17
HAPPY HOLIDAYS TO EVERYBODY AND SUCCESS IN 2011
ALL THE BEST FOR PIPHUT
March 28, 2011 at 08:09
great site! bravo! i got a question.what if i set my SL at 40 pips and TP at 60 pips and gradually when the price is going to my desire direction,then i set trailing TP with a distance about 30-50 pips behind the current price.what is the risk ratio for the trailing TP above?
Thanks!
June 6, 2011 at 13:31
Really information is useful to develop strategy. But R/W ratio is a bit difficult to practice.
December 26, 2011 at 11:42
Deadly accurate anewsr. You\’ve hit the bullseye!
December 27, 2011 at 08:11
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January 19, 2012 at 12:43
So Mark I’m trying to understand how you use the money management principle with the style you trade. It seems that you enter 4 positions per trade and then close each one out 20 to 25 pips from initial entry? Or do you mean 1st take profit at 20 pips then 2 nd at 45 pips 3rd at 70 pips etc.
The loss would be conpounded 4 times so how do you factor this in to your trade results? Even for the positive trades, if the first position was only hit then it would be 20 pips on 1/4 of the total position which is essentially 5 pips on the total trade size. Please help me to understand if I have this correct thanks!
January 19, 2012 at 18:06
Hi Nik, we usually use a single lot (though many hutters do use multiple lots in the manner you described).
In general we never take profit until the last target is reached. We do move our SL up as the price moves in our direction though. If you look back at past analysis you will see comments like “price moved 80 pips in the direction of our trade but we only booked 40 as we were keeping our trade open for 100 pips”. In that type of scenario we have trailed our SL up to +40 even though price is at +80 and then price turned on us.