- How a strong focus on risk:reward and winning % can enhance your overall trading system.
- Why you need to risk less than 5% on any given trade and a lesson on drawdown.
There are two very important concepts in forex trading that you should strive to fully understand. The first is the risk:reward ratio where experts typically advise that you should aim for a value of no less than 1:2. The second is your percentage of winning trades. Obviously, a value of 50% and greater is preferable. However these two aspects are closely related and it is essential that you understand both in order to optimize your trading.
You should note that you can achieve successful trading over the long haul if you manage to get a risk:reward of 1:1 supported by a winning percentage of 50.1%. Combining these two concepts together constructively can have a huge positive impact on your trading. Logging all your trade results as stated in Chapter one will help you assess your direction.
To understand the importance of these two concepts, realize that the essential difference between forex novices and experts is that new traders think about how much money they can make while professional traders think about how much money they can lose. To obtain a deeper understanding of this, let us analyze the different ways a novice and an expert would approach the following trading situation.
On a one-hour chart, the RSI is below 30 and is just beginning to rise which many interpret as a buy signal. A new trader could enter a trade at this point but with no money management or trading strategy. Assume that the market first moves against the trade by 20 pips but then rises back to a profit of 10 pips at which the trade is closed. After three wins in a row, a fourth trade is entered and again the market moves down against the trade by 20 pips. However, this time the market drops another 30 pips before the trader closes down the position. After four trades, a loss of 20 pips is recorded despite having made 3 clear wins. In fact, many new traders win 75% or better of their trades only to lose money in the process. Something is going wrong.
Experts, on the other hand, will analyze the same position but with the use of their trading systems which have both a positive win:loss ratio and expectancy values. They will also apply a sound money management strategy to assess acceptable losses and realistic profits. As such, they will view this new position as part of a trading sequence. The first thing they will do, after selecting their possible entry point, is to identify the price at which they will place their initial protective stop in order to limit their losses. Since they know how many pips they are willing to risk on the trade, they also know how many lots they can open to keep the total risk on the trade to 5% of their account balance or less. They also know that in order to be profitable in the long run they have to make more when they are right than they lose when they are wrong, typically twice as much.
For instance they may only win half of their trades, but may average 50 pips on the losers and average 100 pips on winners. So after four trades, they lose two for a total of 100 pips and win two trades for a total of 200 pips for a total gain of 100 pips. Their trading strategy has successfully provided them with a 1:2 risk:reward ratio. The risk:reward ratio and winning percentage concepts can also be used to minimize the very negative effects of the following serious problem in forex trading.
If you were to lose 50% of your account on a single trade, going from $10,000 to just $5,000, as a result of an unexpected market move, you would then need to gain 100% just to recoup your initial position. This is known as a drawdown and it can have an insidious effect on your account balance. Here again, correct deployment of the risk:reward ration and winning percentage will help you control this problem. For example, assume your initial balance was $10,000 and your results over 10 trades were respectively 20% loss and 20% win:
As a result of the draw-down effect, recovering from consistent loses gets increasingly harder.
You need to avoid these situations by using a well-constructed risk:reward ratio which simply expresses the quotient of maximum risk and maximum reward from a single trade.
This is best achieved by gaining a thorough understanding of money management strategies. One of which could state that the maximum percentage of your available account balance that will be risked on any one trade is 5%. As an example, if you use a risk:reward ratio of 1:2 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately losing 10% and winning 20% of your account:
From these results, you can now see that you have mitigated the draw-down problem using the risk:reward ratio and winning percentage concepts. Whilst performing your back-testing, one of the parameters that you will need to pay close attention is the historic frequency of draw-downs.
Once achieved, a risk:reward ratio needs to be determined with a value of at least 1:1 altogether with a win:loss ratio preferably greater than 80%. This is best achieved by creating a trading system based on a set of consistent rules that have been extensively back-tested. Trying to improve the risk:reward from 1:1 to 1:2 and also increasing the winning percentage of trades by maybe using a larger stop loss, can improve your trading immensely. Also, if you combine the information stored within your trading log while increasing your winning percentage and risk:reward, this action can have even further positive impacts on your trading. To achieve these goals, you need to define a methodical and easy-to-follow plan that will help you, maximize profits and minimize risk before risking large amounts on live trading.
You must learn to adopt a scientific and business-like approach to trading the forex market. You need to realize that there is big difference between risking 2% and 10% of your total account per trade. Ten trades, risking only 2% of the balance per trade, would lose only 17% of the total account if all were losses. Under the same conditions, 10% risked would result in losses exceeding 66%.
You must appreciate quickly that the most successful forex traders are first skillful survivors and only secondly become big earners. Even a trading system with a mediocre but positive expectancy can be turned into a money machine with the right money management techniques. Money management is a study that mainly determines how much can be spent on each trade with minimum risk. For instance, if too much money is risked on a single trade then the size of a potential loss could be so great as to prevent users realizing the full benefit of their system’s positive expectancy over the long haul. The important concept is “do not risk too much of your balance on any one trade”. If you strive to integrate these ideas into your trading strategy backed by the concepts of the risk:reward ratio and winning percentage, then you will greatly increase your chances of being a successful forex trader.