For some reason, many people do not spend enough time analyzing their decisions while trading. A sad study from Statistic Brain says that 80% of all day traders lose money over the course of 6 months of the active trading.
Want to avoid the fate of those 80%? Learn about a simple way to improve your Forex money management plan to start looking at each of your investments from a more objective point of view.
Whenever you start thinking about investing money, you take into consideration many factors including the size of investments, possible returns, and risks.
The relationship between the last two is quite important to evaluate the effectiveness of any investment properly. There should be a term for it. It exits and it is not that fancy.
Here is how we call it in the financial analysis:
The risk/reward ratio.
It is a Meticulous planning that allows us to gain calculable profits always involves the risk/reward ratio calculation. There is no better way to look at the large picture objectively and understand whether you should invest your money.
The ratio can be easily calculated by dividing a potential reward by a potential risk. The result you get is your ratio. The higher the number, the better chances your investment is going to bring you considerable profits.
This ratio is only a small aspect of a much bigger analytical process that involves a lot of important calculations. Math can be scary but not in our case.
When analyzing the potential of any investment, you should consider a multitude of factors.
Calculating the risk and reward ratio is quite easy and diverting.
Here’s an example:
You spend some time looking at the movement on the chart and see a good opportunity to gamble on an upcoming price correction.
You measure all the lines carefully and expect that the correction should take place within a couple of days and return back to the previous position. You expect a possible return of $100 if you invest about $1000.
Here is the calculation:
$100/$1000 = 0.1 which translates into the 0.1/1 ratio.
For the vast majority of situations, this is a very bad investment. Most reasonable investors will not invest until they can readjust the investment to the ratio of 4/1 or at least 2/1.
You could exclaim that it is impossible to earn $2000. However:
You can always set a stop-loss point to mitigate further risks. The risk can be adjusted according to your specific situation. In our case, we can simply set a stop loss at $50. It means that the actual investment is only $50, therefore the ratio now is:
$100/$50 = 2 which translates into the 2/1 ratio.
This is a more reasonable scenario. The prospect seems absolutely positive. You lose only $50 but you can get $100. This sounds like a great deal. The problem is that there are many other important factors that should be taken into account when analyzing your investments.
The timing, length, and probability of the positive scenario should all be accounted for. The price might stagnate at a certain level for a long time meaning that your investments will be “locked” for an extended period of time. This may also reduce the effectiveness of investments even if you earn those $100.
The main idea is that you should not rely on a single formula. It’s better to use it only as part of a much more expansive analytical process. If you still think that the calculation is too complicated, watch a video from Investopedia.
We all know that there is no reward without a risk in the world of finances. One simply cannot eliminate risks from the equation and get nonchalantly from $100 to a villa on a sunny beach. You have to evaluate each step carefully and think when and where you should take a risk to get an appropriate reward.
We have to take certain risks in order to earn money. A trader should never trade when all odds are stacked against the success. A trader should think in percentages. While a $1000 income sounds like a nice sum of money to have, investing $5000 to get this reward is ridiculous.
Read this mindfully:
The reward should be growing relatively to the growth of your investments. If you do not see your portfolio evolving in accordance to this rule, something is going wrong.
When evaluating an investment, you must not think whether the reward seems like a big sum of money. You may have a special set of standards and compare the sum to them.
$1000 is a quarter of a used car that you wanted or a new audio set that would fit your room perfectly. However, it is still a 0.2/1 investment. It is merely a 1/5th of your investments. 0.2/1 is so far away from 2/1 that you should not even think about it.
There is a simple guide that consists of several consecutive steps that help you to pick the right investment. Here it is:
After finding the right investment, you should apply other means of evaluation and decide whether you need to start working with this particular idea. Risk/reward ratio is considered by many traders a fundamental part of analysis.
This is why you should incorporate this ratio in every single decision that you make in the financial market. A proper evaluation of the deal is what will separate you from a big number of other people.
You should always adjust your deal according to your standards regarding the risk/reward ratio. While you can spend time on theoretical analysis, without practical application, all your methods will be useless. You must know how to use acquired data and implement effective solutions and methods in your trading routines.
The problem of many inexperienced traders is that they do not know how to set limits. Both profits and losses should be properly limited in order to achieve true efficiency in trading.
How can you use the risk/reward ratio to adjust your Forex deals correctly? Use your estimations and math to set up deals with the correct stop-loss and take-profit values. Know your limits and do not be greedy.
All seasoned veterans and people who learned the intricacies of the market have one thing in common – they know how to cut losses in a timely manner. All Forex brokers will allow you to set a stop-loss order. When the deal starts going south, you will not lose more than a certain amount of money that you decided to put at risk.
Look at this example:
You think about opening a deal on the USD/EUR pair and look to earning 100 pips. Most brokers have their own spreads and commissions. Let’s say that your actual profit is about 90 pips. Potential loss is all your investment if you don’t set a stop-loss order. You can set it at 45 pips to achieve the 2/1 ratio.
One pitfall that lies in wait for all traders is that Forex seems like a place where the actual reward size is infinite, but it is an illusion that you should never believe.
Various means of fundamental and technical analysis will help you to calculate probable profits but your calculations most often will mean you have to set stop-losses according to approximate estimations. You can read more about the stop-loss orders on Investopedia.
One of the good rules is to have a specific amount of money that you are willing to risk when opening a deal. This will allow you to follow the reverse analytical process.
Here is the deal:
This is a good practical tip for anyone who wants to invest in Forex. Usually having smaller risks means more conservative slow trading. Higher risks are for aggressive traders. You should always try to be somewhere in between in order to trade more or less efficiently.
Calculating the risk and reward ratio should be your second nature. It should function like “spider sense”. Whenever you see an investment with potential, you should immediately take your trusty calculator and start doing math. This will allow you to filter out those deals that may look interesting but have a very small reward in comparison with the risk required to get it.
At the same time, some deals that have great potential to end up bringing you smaller profits can become much more efficient due to a better ratio. A trader who wants to achieve good results should develop a habit and calculate the R/R ratio constantly.
Even a rough estimation will help you to adjust various parameters of any deal correctly to make it more profitable. Developing a habit like this is a necessity for all traders. In the long run, only good ideas and proper evaluations can help you to reach your financial goals.
Another good tip is to never think of the deals you ignored due to the fact that they don’t fit your requirements. Some of them will result in huge profits for someone, but they are not your missed opportunities. Those are the opportunities that you took, analyzed, and decided to stay away from.
Not jumping on the hype trains and slowly working your way towards prosperity is a strategy based on avoiding huge risks at all costs.
Having good discipline is what makes a good trader. Start calculating the R/R ratio for every single deal that you see. Whether you want to take your chance or consider it a bad move, analyze it through the prism of the R/R ratio.
Make it into your habit and stop deviating from your strategy. Stick to it and you will be rewarded.
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This way you can spend as much time as you need to sharpen your money management skills and grow your confidence as a professional trader.
If you have more information concerning the Risk/Reward topic, share it with us in the comment section!