Where beginning traders run into trouble is becoming “convinced” that THIS setup is a winner; it just looks SO solid to them that they don’t see how it could possibly not work out. They then proceed to over-leverage because they are so convinced of the trade setup, and the stage is now set for an account blow-out.
The setup may indeed workout and the trader may clean up, but you can be assured it only takes ONE episode like this to lose a huge chunk of your trading account and kick off a cascade of emotional trading mistakes. This is how losing traders think about the market; they forget that each trade setup is simply another execution with about the same probability as any other similar setup; they do not have a thorough understanding of risk to reward scenarios or position sizing. This article will hopefully give you that understanding.
Thinking in Probabilities
Aspiring forex traders often spend countless hours searching for that perfect trading system which they think will make them rich by following a particular set of trading rules in a robotic manner. Unfortunately, most traders fail to realize that the real “secret” to successful forex trading lies in a thorough understanding and implementation of risk reward scenarios and position sizing. Forex trading is at its very core a game of probabilities, to become a consistently successful forex trader you will need to view each trade setup as a probability. When you learn to think in probabilities you will be on the path towards trading success, because you will be viewing the market from an objective and mathematical mindset instead of an emotional and illogical mindset.
What ultimately separates winning traders from losing traders is how they think about the market. Winning traders view each trade setup as just another execution of their trading edge, they then think about how to minimize their risk on the trade while simultaneously maximizing their reward. Through the power of risk to reward scenarios and position sizing, professional traders know how to effectively manage their risk on each trade and as a side-effect of this knowledge they also manage their emotions. When you begin to view each trade setup as just another execution of your trading edge and effectively implement position sizing and risk to reward scenarios, you will also be managing your emotions because you know your possible risk and possible reward BEFORE you enter the trade, you then set and forget the trade and therefore there is nothing to become emotional about.
The Not SO Secret, Secret.
Anyone who has studied forex trading for any period of time has undoubtedly heard the old axiom “Cut your losers short and let your profits run”. The funny thing about this saying is that no one ever really expands on it by telling you HOW it is actually done or how it can be applied to today’s forex markets. Most traders hear this and they begin by setting really small stop losses with unrealistically huge targets on each trade. The problem with this is that the forex market does not move in a straight line, it ebbs and flows, sometimes having a large move and then an even larger correction before swinging back in the original direction. If you do not properly understand the power of risk to reward scenarios and position sizing, this volatility will end up killing you sooner rather than later.
Risk to Reward Scenarios
Let’s get right to the meat of this issue now, risk to reward scenarios are what you should be thinking about every time you find a trade setup. If you are trading price action strategies for example, you might find a really good looking pin bar formation on the daily chart…the first thing you want to do is define your risk on the trade. Risk management should be your main concern as a forex trader, most traders take the other route; worrying mainly about rewards and not actively managing their risk. Get that idea out of your head. From now on you are to think of yourself as an aspiring professional risk manager, get the whole idea of becoming a professional trader out of your head. Once you learn that risk management is the most important aspect of trading you will become a professional trader as a result, so concentrate on effective risk management and the reward aspect will take care of itself.
Back to our example…you have found a great looking pin bar strategy on the daily chart, now you must find the safest place to put your stop loss so that the probability of it getting hit is as low as possible, you want to give the trade as much room as possible to work out while still maximizing your risk to reward scenario.
In this daily gold chart we can see a pin bar has formed in the context of an uptrend. Your stop loss is placed just below the low of the pin, if you enter at the pin bar closing near $1175.00 your stop loss will be about $20/oz because it would be near the low of $1156.35, we will say $1155.00 to make it an even $20. Now, how do you figure your reward now that you have properly defined your risk?
It depends on the condition of the market you are trading. For this example of gold, it was in a very strong uptrend at the time, in this case it is acceptable to expect a reward of at least triple the amount you have risked or more. In this particular example we exited near $1215.00 for a risk to reward of 1:2, meaning we made 2 times our risk on this trade setup.
This is but one example of the many risk to reward scenarios that setup themselves up each day in the markets. When you have a strong entry method, like price action setups, combined with an understanding of risk to reward scenarios you begin to think in probabilities. This is how professional traders think about the market. For example, if this same pin bar setup above occurred in a range-bound market or in the course of a downtrend, you would not likely set a target of more than 1 to 2; therefore the trade would be a lower probability setup. This is what is meant by thinking in probabilities. You must learn to take into consideration the strength of the price action signal in question but also the context it is occurring in. Many traders simply set unrealistically large profit targets for their trades with no rational behind them besides greed. I can promise you that you will blow out many trading accounts if you don’t learn to take profits by setting logical reward scenarios of 2, 3, or 4 times your risk, if you trail your stop you can sometimes pick up 5 times your risk or higher, it all depends on market conditions and whether or not you can deal with letting a 1 to 2 or larger winner turn around and move against you because you were hoping for a bigger reward.
Position sizing is the glue that holds risk to reward scenarios together. Where most traders mess up in position sizing is in fitting their stop loss to their desired position size instead of fitting their position size to their desired stop loss. For example, say you are risking $100 per trade and you see a really good trade setup. The only problem is that the most logical spot to place your stop loss is 200 pips away. This is a critical juncture where many traders make a mistake; if you need to place your stop 200 pips away to give your trade the best shot at working out, than you simply reduce your position size down to meet this stop loss size. So if you were trading 1$ a pip before, now you will trade .50 cents a pip, .50 x 200 = $100.
To illustrate the example of adjusting your position size to fit the necessary stop loss let’s look at a daily chart of AUDUSD currency pair. Notice in this example our desired risk amount is $100, but our necessary stop loss distance is 109 pips, because the safest spot for our stop loss in this example is just below the low of the pin bar. So, after dividing the risk amount by the stop loss distance (1oo / 109), we get .917. Now, some forex brokers allow you to trade micro-lots, this basically means you have the flexibility to trade a position size as small as 1 penny per pip, in this case you could trade 9.1 micro lots (.91 cents per pip), you would not want to go up to 9.2 micro-lots because your risk would then be over $100: (.92 x 109 = 100.28$), at .91 your risk will be just under $100: (.91 x 109 = $99.19). If you use a broker that does not allow micro-lot trading than mini-lots are your next option, typically these are flexible up to .10 cent increments, this means you can trade .10 cents per pip at the smallest position size. In this case you would just trade .90 lots which would be (.90 x 109) $98.10 risked. This is how you should view position sizing; always adjust the number of lots you trade (position size) to meet the stop loss distance that gives your trade the best chance of profiting. NEVER adjust your stop loss to meet a desired position size, this is GREED.
It really is as simple as that. Most traders end up doing the opposite of the above example however. They end up arbitrarily placing their stop loss just so they can trade a larger position size, this is a mistake born out of greed and will end up killing your trading account in the end. Proper usage of position sizing not only means you will have more winning trades, but it also means you will trade more objectively, because you are placing your stop loss at logical points above or below support or resistance levels, instead of randomly placing it a set amount of pips away from entry. When you combine position sizing with risk to reward scenarios you truly have a “set and forget” trading method which will put you in the proper trading mindset; calm, confident, and objective. There is simply no need to risk more than you should on any one trade when each trade is simply another execution of your edge. This edge may take 100 trades to play out and bring you consistent profits, so to put too much emphasis on any one trade is simply a mistake.
On each trade you make, you should use our Forex Trade Position Size Calculator Here.
Give yourself the best shot at becoming a consistently profitable forex trader by combining a great method like price action with the power of position sizing and risk to reward scenarios. To learn more about these concepts check out my Forex trading course.