By: Terry Allen
There are two very important concepts in Forex Trading that you should strive to fully understand. The first one is the risk to reward ratio. Many experts recommended that you should target a value of 1 to 2. The second one is the win to loss ratio and a minimum value of 50% or greater is advised.
To demonstrate the importance of these two concepts, you need to realise 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 the one hourly EURUSD chart, a buy signal is generated as the RSI begins to crossing back above its 30 value. Novices would now consider entering a position but without using any trading or money management strategies. Assume that in the first three trades, the market moves against their positions initially by 20 pips before profits of 10 pips are realised in each case.
However, the fourth trade just keeps reversing until a loss of 50 pips is recorded. Consequently after 4 trades, the beginner would have recorded a 20 pip loss despite winning three out of four trades. In fact, many new traders win 75% of their trades only to lose money in the process. Their trading strategies are definitely flawed.
Experts, on the other hand, will analyze the same positions
but with the use of their trading systems which have both
positive win to loss ratios and expectancy values. They will also determine acceptable losses and realistic profits for each trade using their money management strategies. After identifying suitable trade entry points, they will then determine the positions for their optimum stop-losses. Finally, they will then be able to calculate the number of lots that they can open so that no more than 2% of their total balance is ever risked per trade.
Experts also know that in order to obtain long term profits, they need to earn more when they are right than they lose when they are wrong. Ideally, they aim for twice as much. In this example, after four trades they could lose two for a total of 100 pips but win two trades with a total of 200 pips resulting in a total gain of 100 pips. Their trading strategy has successfully provided them with a 1 to 2 risk to reward ratio.
By: Terry Allen