Where novice traders often encounter problems is when they become overly convinced that a particular trading setup is a surefire winner. They see it as incredibly solid and fail to consider the possibility of it not working out. Consequently, they end up over-leveraging their trades due to their unwavering conviction, setting themselves up for a disastrous account blow-out.
While it is true that the setup may indeed turn out to be profitable and the trader may make a significant profit, it is important to recognize that just one incident like this has the potential to wipe out a substantial portion of the trading account and trigger a chain of emotional trading mistakes. This is the mindset of losing traders who overlook the fact that each trade setup is essentially another execution with similar probabilities to other comparable setups. They lack a comprehensive understanding of risk-to-reward scenarios and position sizing. The purpose of this article is to provide you with that understanding.
Embracing Probability Thinking
Many aspiring Forex traders invest countless hours searching for the elusive perfect trading system, believing that following a specific set of rules will magically lead them to riches. However, what most traders fail to recognize is that the true “secret” to successful Forex trading lies in developing a comprehensive understanding of risk-reward scenarios and position sizing. At its core, Forex trading is a game of probabilities. To consistently succeed in this field, you must perceive each trade setup as a probability. By adopting a probabilistic mindset, you will pave the way for trading success, as you approach the market from an objective and mathematical perspective rather than an emotional and irrational one.
The differentiating factor between winning traders and losing traders ultimately lies in their mindset. Successful traders perceive each trade setup as another execution of their trading edge. They focus on minimizing their risk while maximizing their potential reward. Through the effective utilization of risk-reward scenarios and position sizing, professional traders adeptly manage their risk on every trade and, as a result, also regulate their emotions. By viewing each trade setup as a mere execution of their trading edge and implementing position sizing and risk-reward scenarios proficiently, traders also gain emotional control. They are aware of the potential risks and rewards before entering a trade, set their parameters, and let the trade unfold without becoming emotionally entangled.
The Not-So-Secret Secret Revealed
Anyone who has delved into Forex trading for a considerable period has likely come across the timeless adage: “Cut your losers short and let your profits run.” Interestingly, this statement is often left without further elaboration, neglecting to explain the actual implementation or its relevance in today’s Forex markets. Many traders simply hear this advice and proceed to set extremely tight stop losses while aiming for unrealistically large targets on each trade. However, this approach fails to acknowledge the fact that the Forex market doesn’t move in a linear fashion; it fluctuates, experiencing significant moves followed by substantial corrections before resuming its original direction. Without a proper understanding of the power behind risk-reward scenarios and position sizing, this inherent volatility can swiftly lead to detrimental outcomes.
Risk-to-Reward Scenarios: Maximizing Trade Potential
Let’s dive straight into the heart of the matter – risk-to-reward scenarios should be at the forefront of your mind whenever you come across a trade setup. If you’re trading price action strategies, for instance, and you spot an attractive pin bar formation on the daily chart, your initial focus should be on defining the risk involved in the trade. As a Forex trader, your primary concern should revolve around effective risk management, rather than fixating solely on potential rewards. It’s crucial to dismiss the notion of pursuing a professional trader status and instead embrace the mindset of an aspiring professional risk manager. By understanding that risk management holds utmost importance in trading, you will naturally progress towards becoming a professional trader. Therefore, concentrate on mastering risk management, and the rewards will follow suit.
Returning to our example, let’s say you’ve identified a compelling pin bar strategy on the daily gold chart. Now, your objective is to determine the safest placement for your stop loss, minimizing the probability of it being triggered while allowing ample room for the trade to unfold and optimizing the risk-to-reward ratio.
In the given scenario, a pin bar has formed within the context of an uptrend. To manage risk effectively, you would place your stop loss just below the pin bar low. If you enter the trade near the pin bar’s closing price of around $1175.00, your stop loss would be set at approximately $20 per ounce, taking into account the low at $1156.35 (let’s round it to an even $20 at $1155.00). Now, with the risk defined, how do you calculate the potential reward?
The reward expectation depends on the market conditions in which you are trading. In this gold example, given the strong uptrend at the time, it is reasonable to anticipate a reward of at least triple the amount you risked or even more. In this particular case, we exited the trade near $1215.00, achieving a risk-to-reward ratio of 1:2, meaning we earned twice our risk on this trade setup.
This is just one illustration of the various risk-to-reward scenarios that present themselves daily in the markets. When you possess a robust entry method like price action setups and combine it with an understanding of risk-to-reward scenarios, you begin to think in probabilities. This is precisely how professional traders approach the market. For instance, if the same pin bar setup occurred in a range-bound market or during a downtrend, it would be imprudent to set a target greater than 1 to 2, making the trade a lower probability setup. This exemplifies the concept of thinking in probabilities. You must consider both the strength of the price action signal and the context in which it occurs. Many traders erroneously set unrealistic profit targets driven solely by greed. I can assure you that unless you learn to take profits by setting logical reward scenarios of 2, 3, or 4 times your risk (or potentially higher if you trail your stop), you will likely deplete numerous trading accounts. It all depends on market conditions and whether you can handle a winning trade of 1 to 2 or more turning around and moving against you because you were aiming for a larger reward.
The Importance of Position Sizing
Position sizing serves as the crucial link that ties risk-to-reward scenarios together. Unfortunately, many traders make a common error when it comes to position sizing: they try to adjust their stop loss to fit their desired position size instead of adapting their position size to accommodate their desired stop loss. To illustrate this point, let’s say you are willing to risk $100 per trade and you come across a highly favorable trade setup. However, the optimal placement for your stop loss is 200 pips away. This is a pivotal moment where many traders stumble. Instead of forcing your desired position size and compromising on the stop loss, the correct approach is to adjust your position size to align with the stop loss distance. In this case, if you were originally trading at $1 per pip, you would reduce your position size to $0.50 per pip ($0.50 x 200 = $100).
To further exemplify the idea of adjusting position size to accommodate the necessary stop loss, let’s consider a daily chart of the AUDUSD currency pair. In this example, let’s assume our desired risk amount is $100, but the stop loss distance required is 109 pips, as the safest spot for our stop loss is just below the low of the pin bar. By dividing the risk amount by the stop loss distance (100 / 109), we obtain 0.917. If your Forex broker allows micro-lot trading, providing the flexibility to trade as little as 1 cent per pip, you could trade 9.1 micro-lots ($0.91 per pip). It is essential not to exceed 9.2 micro-lots, as that would result in a risk over $100 ($0.92 x 109 = $100.28). Opting for 0.91 micro-lots would keep your risk slightly under $100 ($0.91 x 109 = $99.19). If your broker does not offer micro-lot trading, the next option would be mini-lots, typically available in increments of 0.10 cents per pip. In this case, you would trade 0.90 lots, resulting in a risk of $98.10 ($0.90 x 109). This illustrates the correct approach to position sizing—always adjust the number of lots (position size) to align with the stop loss distance that maximizes the trade’s potential. Never adjust your stop loss to fit a desired position size; this is driven by greed.
It truly is as straightforward as that. However, many traders end up doing the opposite of the aforementioned example. They arbitrarily set their stop loss to accommodate a larger position size, succumbing to greed. This mistake ultimately jeopardizes their trading accounts. Proper utilization of position sizing not only leads to more winning trades but also promotes objective trading. By placing your stop loss at logical points above or below support or resistance levels, rather than randomly determining a fixed distance from the entry, you trade with objectivity. When position sizing is combined with risk-to-reward scenarios, it creates a “set and forget” trading approach, fostering a calm, confident, and objective mindset. There is no need to risk more than necessary on any single trade when each trade represents another execution of your edge. Your edge may require 100 trades to manifest and consistently generate profits. Therefore, placing excessive emphasis on any single trade is simply an error.
On each trade you make, you should use our Forex Trade Position Size Calculator Here.
Give yourself the best opportunity to become a consistently profitable Forex trader by combining a solid method like price action with the power of position sizing and risk-to-reward scenarios.