Winning More Trades
In Lesson #2: Forex Money Management, I said that you need to have at least 2:1 risk/reward ratio (for example if you are risking 10 pips your goal is at least 20 pips). I called this money management technique the "backbone to successful forex trading". But what I hear a lot of is: "Ok, 2:1 ratio is great, but what if I'm not winning 33% of my trades??"
I recently got a great question that summed this up from a piphutter on my original money management article that it sparked me to write an entirely new article for you regarding how to win more of your trades.
Below is the trader's question regarding money management:
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...
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... I know that every trader has experienced this and I am interested to know your views and methods to you resolve such a position?
Basically he is saying "It seems like I would win more trades with a 1:1 ratio - what gives??"
Here is my respose for you all:
It is a good question and a healthy one to ask yourself. The quick and dirty answer is that you need to look at the long term picture. In the short term a 1:1 ratio or less may mean you win more trades but eventually, when the market starts behaving differently, you will start losing money. Don't forget, the whole reason for using proper money management is because with a 1:1 risk/reward ratio you have to win 50% of your trades to break even. At 2:1 risk/reward ratio you only have to win 33% of your trades to break even!
What you more than likely need to focus on is winning more trades in the short term, and being more selective about the positions you take.
So how can you win a large percentage of your trades?
- Basically it is a combination of risk reduction techniques - reduce the risk, and you increase the odds that your trades will be successful. I can make bad or even borderline trades all day. I can analyze, draw support and resistance and check the slow stochastics but if my analysis isn't correct, or other traders are buying or selling off different criteria. I'll give you a variety of techniques I know other traders use and what I prefer myself. It starts with the basic up to the more advanced:
- Use larger time frames - the larger the time frame, the better the signal. At larger time frames the price action is more relevant, technical indicators such as RSI, slow SS and others produce better signals. Big money, or "smart money" is what moves markets. And smart money is not looking at the 30 minute chart. They are looking at the daily or higher. I prefer the 4 hour chart because it generally gives you the same picture as the daily while also giving you better entry and exit points and produces enough signals while still being reliable.
- Place stops above or below major support and resistance levels. I've even heard of traders waiting until just a few pips before where they would have wanted their stop. This method produces fewer trades (often the price never reaches the level) but the trades are generally more profitable. Also, make sure you are looking at larger timeframe charts for your support and resistance. What might look like support on the 1 hour chart might not be support at all on the daily chart.
- Take a look at the ATR if volatility is the issue. The ATR, or average true range shows you the volatility, or range, of any pair on any given time frame. If the ATR shows a range of 25 pips. Make sure your stop is at least 30 pips (to include the spread) from the support/resistance, or from wherever you expect the pair to turn around.
- Use a Micro Account - if you are struggling with using a 50 pip stop with a standard lot (1 pip=$10 so a 50 pip stop is $500) then use a micro account. Many brokers offer micro accounts - not all, but many - and 1 lot in a micro account is 1/10 the size. If 1 pip is only $1 then a 50 pip stop would only be $50.. That way you can have that 50 pip or 100 pip stop and only risk $50 or $100. Your profits are also more limited - but if it is the difference between profitability and debt then take profitability any day!
- Multiple lots - a strategy that I use frequently and I know other traders do to is to use multiple lots. If your stop loss is 30 for both of them then set the take profit (or limit) on the first lot to 30 pips as well. If and when the first goal is reached and the first lot closes for a profit of 30 pips move the stop loss on the second lot to break even. Now you are guaranteed 30 pips profit and you now have a lot that is 30 pips in the profit that you can let run!
- Use entry orders - catch your pair moving in the right direction! Another way of saying this is "don't stand in the way of a freight train!" If you are trying to catch a reversal don't buy it on the way up! If it has shown no sign of reversal then why would you sell a pair that is on the way up? You will quickly find yourself underwater. This alone is what my breakout strategy consists of. I often will place a buy order above resistance (or sell order below support) because I know if major support or resistance is broken you will usually see a 30-40 pip run.
- Use a demo account - if you get a string of losses and you feel your confidence waning don't beat your head against the wall and keep risking your money on a system that might be flawed. Boot up that demo account and demo trade for awhile until you see a return to consistent profits. Make sure you journal your trades and revisit them so you can see what you are doing well and what you still have to work at.
There are more but in the end it boils down to this: simply using a 2:1 ratio isn't enough if your trades are great trades to begin with. But I believe Ed Ponsi said it best with something to the effect of this: If you can only enter trades that you feel are so great that they look like absolute no brainers - you will succeed.
As always trading in the foreign exchange market is a risky business. The above lesson is just my opinion - you should always consider your goals and consult a financial professional before investing your money.