on Tuesday, December 2, 2014

Know your Risk: The Risk-Reward Ratio

Risk is a part of trading. Every trade carries a certain level of risk. Every trader must know the amount of risk that is being assumed on each trade. Knowing the amount of risk on each trade is one way to limit it and to protect your trading account. The best way to know your risk is to determine the risk-reward ratio. It is one of the most effective risk management tools used in trading.
The risk-reward ratio is a parameter that helps a trader to determine the level of risk in a trade. It shows how much a trader is risking versus the potential reward (or profit) on a trade. While this may seem simplistic, many traders neglect taking this step and often find that their losses are very large.

How to Determine the Risk-Reward Ratio?

The first step is to determine the amount of risk. This can be determined by the amount of money needed to enter the trade. The cost of the currency multiplied times the number of lots will help the trader to know how much money is actually at risk in the trade. The first number in the ratio is the amount of risk in the trade.
The reward is the gain in the currency price that the trader is hoping to earn from the currency price movement. This gain multiplied times the number of lots traded is the potential reward. The second number in the ratio is the potential reward (or profit) of the trade.
Examples
Here are a few examples of the risk-reward ratio:
·        If the risk is 200 and the reward is 400, then the risk-reward ratio is 200:400 or 1:2.
·        If the risk is 500 and the reward is 1,500, then the risk-reward ratio is 500:1500 or 1:3.
·        If the risk is 1,000 and the reward is 500, then the risk-reward ratio is 1000:500 or 2:1.

What is a Good Risk-Reward Ratio?

The minimum risk-reward ratio for a Forex trade is 1:2. However, a larger ratio is better. An acceptable risk-reward ratio for beginning traders is 1:3. Any number below 1:3 is too risky so the trade should be avoided. Never enter a trade in which the risk-reward ratio is 1:1 or the risk outweighs the reward.
Many experienced trader will only enter trades in which the risk-reward ratio is 1:5 or higher. This requires that the trader wait for a trade with this ratio, but the reward is worth it. A higher risk-reward ratio is a good idea in case the currency does not make the anticipated price movement. However, if the trader uses a lower risk-reward ratio, there is very little room for smaller price movements and the amount of risk will increase.

The risk-reward ratio is an important risk management and trading tool. It is important for beginning traders to take the extra time to perform this task because it can help to minimize risk in every trade. Waiting for the right risk-reward ratio can take a long time. However, the benefits of waiting for a higher risk-reward ratio are worth the effort and patience. You will know your risk and know your potential profit. Most importantly, you will know whether the trade is worthy of your money.
on Monday, December 1, 2014
Trading can be a lot like gambling if you let it be so. Some of the best traders in the world are also great poker players, but there’s a big difference between how you trade and how people gamble.
How can trading be gambling?
What I’m talking about is the average trader out there that makes references to things such as “Well, I’m taking high-risk trades, but I keep my stops really tight.”
Also, “I’m playing with house money.” That’s one I hear all the time and it just grinds my gears every time I hear that because they make these analogies to gambling almost subconsciously; they don’t even realize they’re doing it.
Let’s talk about that “house money” issue. Is it really house money, or is it money that you worked hard to earn? You pay for subscription services; you’ve read lots of books; you’ve subscribed to great trader interview sites. There are lots of tools out there that people can use to grow their knowledge. You’re paying for that.
Then, of course, the school of hard knocks, where you do take losses and drawdowns during your trading development and career.
So, by the time you finally start to see some consistent profitability, are you really playing with house money, or money that you earned? Is that money just play money, or is that money you’re going to pay your bills with, or grow your account with and be able to trade more size down the road.
It’s not really house money when you have a successful morning. That really doesn’t allow you to take higher-risk trades in the afternoon, and I see that phenomenon over and over.
For instance, I see a lot of people say “I make money in the morning, but I lose money in the afternoon.” As I sit and talk with those types of students, I often find that they do have a successful morning, and then their attitude changes. “Well, now I can double up, triple up, and take a lot more risk because it’s all house money.” They don’t treat it like their own.
It’s so important for people to understand that if you’re making money, that is your money and you need to protect it.
I find that the best professional traders, their mentality is not about how much money they can make on the next trade. It’s about protecting their money and thinking about how much money they could lose on the next trade.
So, that’s one key instance right there, and then the whole concept of risk and risk management. What I find happens with a lot of traders is that they say “Well, yes, I’m taking a lot of risky trades and I’m taking a lot of momentum-based trades. I don’t really have a science behind what I’m doing. I just see the markets shooting real fast in one direction or the other and I chase after that. But that’s okay because I’m keeping my stops tight.”
Well then of course what I see is just like a credit card statement for a person who keeps shopping, the credit card bill comes and you’ve got to pay the piper and you owe this big drawdown, this big debt.
Same thing with these traders; no individual trade is blowing them out, but at the end of the month, it’s death by 1000 cuts because you’ve still got to pay your commissions and all those little losses add up to big losses.
What has to happen there is the mindset has to change. Learn that no, it’s not acceptable just because I’m keeping my stops tight to take a bunch of high-risk trades.
The focus really has to be how can I minimize losses from the very beginning, and keeping stops tight may be perfectly fine, but keeping stops tight on higher-probability trades, and not just saying “Well, I know this is really risky and that’s my style, but I’m keeping my stops tight.”
In the end, ask yourself what is that doing to your trading account month over month, and if you’re seeing continued draw downs, you need to have a mind shift and focus on higher-probability set-ups.
And it also seems to me that if you’re guessing on your trades without having any sort of edge, that again pushes your trading into the gambling arena.
It pushes you into the gambling arena, and then you’re clearly not journaling. You probably don’t have a trading plan if you’re flying by the seat of your pants.

Two fundamental tenets that every trader should have: a trading plan and they should journal those trades, especially if they are in the more junior stages of their career, absolutely.
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