Hello and welcome to another edition of the bulls vs the bears. Look, if you really want to be a successful forex trader you must master risk reward and position sizing like the back of your hand. It’s the most important lesson in money management you will ever win. It’s either you sink or you swim.
Just picture this scenario. You are a newbie trader and you’ve chanced upon this trade setup that you strongly believe will lead you to your first profit of the day. It’s so solid that you don’t understand how this setup could go wrong. Unfortunately you then suffer an acute case of blood rush to the head by over-leveraging on your trading your account. In so doing you set your account up for a nuclear-sized blow out.OUCH! You do not want to trade like a kamikaze head hunter. Instead you’d rather trade based on expected return on your risk reward and position size.
So I’m going to explain risk reward and position size and how to profit using these two elements. Hopefully next time you trade, you’ll keep the blood rush to a minimum. But before you continue with this lesson if you haven’t read Practice Risk Management or You Die As A Forex Trader, I suggest you do so IMMEDIATELY. You will gain a better foundation for today’s lesson.
So we’ll start off with
Risk Reward
Risk reward basically is where you access how to much profits you expect to make based on how much risk you can afford to take. In fact risk reward is absolutely crucial to your forex trading success. It is very important as far as management of your money is concerned. The whole idea behind risk reward is maximizing your profits and cutting down on your risks. Your ability to understand how risk reward works and competent application of risk reward will be the difference between a spectacular forex boom and a nuclear-sized forex bust for you.
Wanna know the secret behind success behind risk reward?It’s easy: Patience. You need the patience to consistently enter trades over a long period of time to harness the power of risk reward.And by risk reward, I’m not merely talking about calculating the risk and reward on a trade. I’m talking about 2 or three times more risk on all your winning trades such that you should be able to profit from your trades even if you lose some trades. So if you consistently apply a risk/reward ration of, say . 1:2, or higher with a high probability trading pattern, it should net you fairly health profits. Let’s look at a pin bar setup to see how to calculate risk/reward.
See how the pin bars were formed in the uptrend. Once pin bars were formed, price surged. Now assuming we calculate a risk of say $100, using a ratio of 1:3. We could make a decent reward of $300. While you are it be sure to place a stop loss just below the low of the pin bar. This allows you the opportunity to calculate how many lots you can trade in spite of the stop loss distance.
The trick here is keeping your emotions in check. Jumping in and out of trades and not taking logical risks is the perfect recipe for a huge account blowout. And just as in the game of life, forex trading is a marathon, not a sprint. It requires a long period of consistent trades backed by logical risk reward and an effective trading strategy.
Next up is
Position Sizing
Ummm- position sizing does not involve sizing up the major players on the market. Far from it. Position Sizing simply involves tweaking the number of lots you trade to align with your risk. Wanna know how it’s done?Well let me break it down like this.
Decide On How Much You Can Afford To Lose On Each Trade
First decide how much you can afford to lose on each trade. You need to deliberate on this and take it seriously.Why? Because your “risky” decision could be the difference between a spectacular forex boom and a nuclear-sized bust for your forex trading account. Next up
Find The Safest Place To Put Your Stop Loss
Find the safest place to put your stop loss. The whole idea is to place your stop loss at a place that will render the trade setup null and void in case it takes a hit, or on the other side of a support or resistance area, If you are into pin bar setups, you’d do well to place your stop loss just above the high/low of the tail of the pin bar. And Please Please Please! DO NOT even entertain the thought of placing your stop loss too close to your entry just because you have this strong urge of trading at a higher lot size. This is nothing but greed and it will come back to bite your behind so viciously you may need a ton of injections to cure the bite. That’s on a lighter side of course.
Finally
Enter The Number of Lots That Will Fetch You Your Desired Risk Profits
Now some of you are wondering “What does he mean by ‘Enter The Number of Lots That Will Fetch You Your Desired Risk Profits'”? Well basically what I mean is you decide how many lots you are going to trade based on your pre-determined risk amount. So let’s say you decide on $1 per pip, your pre-defined risk amount is $100 and your stop loss distance is 50 pips. assume you trade two lots(which should give you $2 per pip), the calculation should be $50 x 2. – which equals $100.
Let me give a little warning though: NEVER EVER tweak your position size to balance out your original position size. Rather tweak your position size to balance out your pre-defined risk and stop loss distance. Failure to do this and your trading account will suffer an atomic-sized wipe out.
One important aspect of position sizing is that you can trade the same risk money on any trade that you decide to enter in. You just ve to tweak your position size so that it aligns with your pre-defined risk regardless of the size of your stop loss. If you find your head spinning thinking you are risking more with a bigger stop or less with a smaller stop. STOP RIGHT THERE! It’s not rocket science.
We’ve talked enough. Haven’t we? Let’s take a look at an illustration of position sizing using the price action of pin bar and inside bar
Here we see the pin bar set at the beginning of the uptrend, and the inside bar setup on the uptrend. And as you may have noticed, these setups require stop losses at different distances.But thanks to the power of position sizing, you can risk the same amount of cash on both setups.Just make sure you don’t overdo things or your account will be hurting terribly.
That’s a wrap for ”Risk Reward and Position Sizing – The Most Important Lesson in Money Management You Will Ever Learn.” You absolutely need to understand risk reward and position sizing like the back of your hand if you wan to reach the promised land as a forex trader. And you need to execute these two aspects of money management, accompanied by an effective trading strategy. You can’t just jump in without a trading plan.
Remember when we touched on “Second Chance at Missed Signals” in my post Should I Use One And Four Hour Chart Time Frames To Confirm Daily Price Signals? Well, in our next lesson we’ll xpand on this point by looking at how to get a s econd crack at trade signals that we missed out on. If you havent read the above post I strongly suggest that you do so before the next lesson. You’ll suffer dearly if you dont.
Till next time take care.
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