This silly, avoidable error can ruin your trading results
In today’s Profit Watch:
• Why you need to be smart about risk
• Understanding the maths
• PLUS: Using support and resistance for trade management
When you’re trying to make money in the markets, it’s absolutely essential to understand reward-to-risk ratios. And while we’re at it, it’s vital to keep to some simple trading rules.
If you don’t, then you risk making the No.1 mistake that causes traders to lose money.
And it’s my job to make sure that doesn’t happen. Pro isn’t just about the trade ideas (although those are largely what you’re here for). It’s also about learning good habits – and killing bad ones.
So whether you’re new to this… or an old hand, be sure to take this on board – it will stand you in good stead as you navigate the markets.
The basic rule I live by on Profit Watch Pro is: go for a positive reward-to-risk ratio.
I told you it was simple.
And to make it easier, always remember a good rule-of-thumb is to go for 2:1 or better.
So you’re risking £1 to make £2 or, in points or pips terms, you’re risking 10 pips to make 20. And if you can get a higher r:r ratio – say 3:1 – then that’s even better.
It sounds pretty obvious: you should aim to make more on your winners than you lose on your losers. But it needs saying again, because all too often traders ignore this common-sense approach.
And when you do, that’s when you lose money over the long term…
The No.1 mistake that causes traders to lose money
Your money and risk management is actually far more important than your success rate.
It’s the thing you’ve got to get right first.
This is borne out by a study carried out by the broker, FXCM, when they set out to find the traits of successful traders.
What the company did was look at the combined anonymous trading data for some 43 million trades made by its account holders over a 12-month period.
What they discovered was interesting – and quite encouraging on the one hand. But it serves as an important warning on the other hand.
Let me show you what I mean.
To start with, FXCM found that across the main currency pairs their clients traded, traders were correct more than 50% of the time.
They made the data into this chart:
So what have we got?
The chart shows results of more than 43 million trades made by traders from the second quarter of 2014 through to the first quarter of 2015.
These are apparently the 15 most actively traded pairings.
The blue bar shows winning trades, red is losing trades, as a percentage of the total.
Take a look at a couple of the most actively traded pairings – let’s say EURUSD (most common) and cable (GBPUSD). On the euro, traders were right 61% of the time and on cable the success rate was 59%.
And as you can see, they were right more than 50% of the time on every single currency pairing.
That sounds quite impressive to me.
Where it all goes wrong
But it’s not as good as it sounds. Because in fact, despite this apparently good performance, most traders still lost money.
To see why, we need to look at FXCM’s next chart:
So this chart shows the average number of pips won or lost on those same trades.
Again, blue is the average gain, red the average loss.
And you can clearly see what’s been happening here: the losses are significantly larger than the wins.
Take another look at the most popular pairing, EURUSD.
You can see that the average winning trade made 48 pips, but the average loser racked up losses of 83 pips.
So although traders were correct more than 50% of the time (first chart), they lost 72.9% more on their losers than they won on winners.
And take a look at cable (GBPUSD) – FXCM’s clients did even worse on that one.
They may have been right 59% of the time on their trades. But they lost 93% more on their losing trades than they banked on winners.
That’s the recipe for disaster!
If you’re using a reward:risk ratio like that, you’ll soon do serious damage to your account.
Now as I mentioned earlier, this study was conducted a couple of years ago. But I wouldn’t mind betting you get a similar picture most of the time…
Remember the golden rule
The lesson is: the most important aim in trading is not to be right all of the time.
It’s far more important that you keep your reward:risk ratio positive…
You must make more on your winners than you lose on your losers – that’s the golden rule.
Remember, with a 2:1 reward-to-risk ratio, you can afford to get 50% of your trades wrong – and you’ll still make money. And with a 3:1 ratio, you only need to get a third right to be profitable.
Make sure you think about that every time you decide where you put your stop loss (risk) and your profit target (reward).
Of course, you still need to place your stop loss and target at levels that make technical sense based on the charts.
I tend to use support/resistance levels, swing lows and highs, as well as major Fibonacci levels. That’s how I choose the levels when I send you one of my trading ideas.
So if I’m long, ideally I want my stop below support (and if I’m short I want my stop above resistance).
As for targets, I usually aim for areas that are just shy of resistance if I’m long (and just shy of support if I’m short).
When you come up with your next trade, please be sure to use these sensible money management and trading rules.
And if you need help with new trade ideas, I’d be happy to start sharing mine with you. Just follow this link and tell me where to send them.