There are many, many ways to do the wrong thing when you are trading the Forex market (as more than a few traders have discovered). Studies have shown that traders are right more than 50% of the time, but they still lose more money on their losing trades than they ever win on their winning trades.
So, what is the “Danger Sign” that investors are missing that makes their trading so wrong?
It comes down to “Risk/Reward”
Simply put, Forex traders should always use stops and limits to ensure a risk/reward ration of 1:1 or higher. Now, this seems very easy to follow when you aren’t in the middle of your trading, but you should close out your trades when your trades go against you before your loss gets too big. When you’re a Forex trader, you’re going to lose — the trick is to lose as little money as possible. Similarly, when your trade is going well, it is often a great idea to let it continue going in the right direction for a few more profits.
Don’t Let Your Emotions Get the Best of You
Unfortunately, humans — with their emotions — can’t easily do this. When things are going bad, we want to wait for things to turn around and get better, and when trades are going well, we want to cash out and start spending our money! Emotion almost always favors the “risk” side of the “Risk/Reward” equation, and while we want to prove ourselves right with our trades (“If I just hang on, this 98% reduction in value is going to go the other way…”), we need to focus on what makes us profitable, whether we’re right or not.
The way to avoid the danger sign is to follow one rule: make sure your reward is bigger than any possible loss. This is your “Risk/Reward ratio,” and it is the most important factor in your trades. Let’s say you are in a trade where you could gain 50 pips, and you could lose 50 pips. Your risk/reward ratio here would be 1-to-1 (or 1:1). This is good, but you know what is better? A trade where you could gain 100 pips while leaving yourself at risk to lose 50 pips. This would be a risk/reward ratio of 1 (the 50 pips you could lose) to 2 (the 2×50 pips you could win).
A 1:2 risk/reward ratio is twice as good as 1:1, but you can do even better if you try. When you’re using lower probability trades (like trend trading) you’ll want to aim for a risk/reward of at least 1:2, and 1:3 or 1:4 would be preferred.
No matter what Forex trading strategy you use, you should always use a minimum 1:1 ratio, because if you’re right only 50% of the time, you’ll still be able to at least break even with your trades.
How do you stay on track once you’ve set your risk/reward ratio? That part is a little easier. All you have to do is make your plan and stick to it. Resist the temptation to take tiny profits or stretch out your losses. Instead, take your emotions out of the equation entirely by using stop-loss and limit orders from the very beginning of your trades. These will help you set the correct risk/reward ratio of 1:1 from the very start — and after you’ve put your strategies into action, keep your hands off of them.
When you do resist the urge to play around with your trades while the market is still moving, you put yourself in the best position to make money no matter whether your predictions were right or not. Successful Forex traders profit even when they are wrong about the market’s direction (which no one can predict accurately all the time!), and they do this by setting the proper risk/reward ratio, let profits run when they happen and cut losses quickly using stop-loss and limit orders.
And here’s another tip: When you place your trades, use a stop-loss order and make sure your profit target is at least as far away from your entry as your stop-loss is. Aim for a 1:2 risk/reward ratio or higher if you can, and then no matter which way the market goes you’ll be in a place where you can make money.