FOREX TRADING AND RISK REWARDS

   FOREX TRADING AND THE RISK-REWARD 

Let's say I have $2,235 in my trading account, and I am happy to risk 2% on each trade.

I'm in my broker’s account looking at their charts and I see a nice setup on the

EUR/USD where I am looking at buying at 1.3928. I am going to place my stop

(stop loss) 30 pips below at 1.3898. So my risk on this trade is 30 pips.

Now I need to know what my position size will be, where I am risking no more than

2% of my overall account balance of $2,235. This equates to $44.70.

The easy way to work this out is by using the following:

Account Balance multiplied by risk percentage, divided by risk (stop size in pips),

equals position size.

In this trade, the math would look something like this:

$2,235 x 2% = $44.70

$44.70 / 30 pips = 1.49

Therefore my position size in this trade would be 1.49 mini lots (0.149 lots). You

would have to round this down to either 1 mini lot (0.1 lot), or 1.4 mini lots (0.14

lots) if your platform allows this trading size.

If you are unsure of the position size, whether it is in standard or mini lots, just do

the math backward to confirm. You know the maximum risk is $44.70 on this trade.

If you went into the trade with 1 mini lot, you know each pip is worth $1, so if you

were stopped out, then you would have lost $30, which is under your max risk of 

$44.70, due to the fact you had rounded your position size down.

Here is another example with a much larger account balance and a different risk

percentage and stop placement.

The account balance is $37,840, your trade risk is 3%, and you are placing an order to

sell the GBP/USD at 1.4562 with a stop at 1.4607, which is 45 pips away.

Let's do the math to work out my position size:

$37,840 (Account balance) x 3% (risk percentage) = $1135.20

$1135.20 (max risk) divided by 45 (stop) = 25.226'

Therefore my position size would be 25.226' mini lots (2.5226 lots) or rounded

down to 25.2 mini lots (2.52 lots) which iare2.5 standard lots.

Do the math in reverse if you want to double-check your position size. You know

your max risk is $1135.20, your stop is 45 pips, and each pip is worth $10 on a

standard lot. If you were to lose 45 pips with 2.5 lots, then 45 x 2.5 x 10 = 1125,

which is under the $1135.20 risk.

It may be a little confusing at first, but it is very simple once you get the hang of it.

By using this formula, you should never have to worry about leverage, margin, or

risk. They just don't come into it. But having said that, it all depends on your risk

percentage levels and your actual trading methods. You do need a successful trading

method because if you don't and you were only risking say 2% per trade, you will

eventually blow out your account. It will just take a bit longer to achieve this than if

you were risking 10% on each trade.

There are plenty of freely available Excel-type spreadsheets that can do the math for

you once you plug in your figures. These are quite handy and ensure you get

the figures correct.

Now we need to talk about risk!

Information on Risk

I consider 'risk' to be a very important issue when it comes to Forex trading.

Probably not so much of an issue if you are a longer timeframe style trader, say the

weekly or monthly charts, but if you are a day trader, then it certainly is an issue.

TRUST ME ON THIS!

Now I don't care what your percentage risk is per trade as that is up to the

individual trader. I have suggested 2-3% which is quite common amongst successful

traders, even less is better according to some. This will ensure you stay in the game

longer at least. If you want to risk 10% on a trade, that is up to you. But I will say

that it is very much in your interest to have a physical stop loss in place.  

What can go wrong you ask?

Other than you picked the wrong direction for the trade, which will happen 

now and then. You may also have internet problems or the biggie, unfavorable

news comes out that completely catches you by surprise and before you know it,

your trade is down a 100 pips or so.

First up, there are potential internet problems. It doesn't matter where you live, you

can never be guaranteed of 100% reliable internet connection. It only takes a storm

within about 100kms of my place to disconnect me at times, and I'm with the biggest

telco in the land. When I was trading full-time back in the mid-2000s, I also had a

backup with the old dial-up to my cable broadband. These days, you can get a

wireless modem as a backup. One other thing I would strongly suggest is that you

have your broker's phone number handy, so you can ring them directly and either

close trades or move stops, etc. I have done this in the past to get out of trouble, and

it is nice to know that you have this option if worse comes to worst. Again, this may

only be available with the bigger well known brokers. It also helps to consider any

possible language problems if you have to get on the phone.

Potentially the biggest problem is news releases or unexpected news. Forex moves

on the news! And there is always plenty of news coming out. The good thing about it is

that most of the news is released at set times which is very easy to keep track of.

Very easy, and I'll go into this in another chapter.

So what am I saying here? MAKE SURE YOU USE STOPS ON ALL TRADES. I

cannot be any clearer on this!

Now the stop depends on you, but please don't make it a mental stop. These just don't

work in Forex trading, especially if trading the smaller time frames. Even if you

have some sort of safety stop that is some distance from your entry to prevent total

wipe-out, which you can adjust later once the trade is up and running, is a much

a better option than having no stop at all.

To give you an example of price movement in a 24hr period, I believe the average

for the EUR/USD is around 100 pips and the GBP/USD is about 120 pips, give or

take. That is just an average move in 24hrs. When I say move, it may start and finish

at the same price, so I am referring to a possible range of movement here. If you

were trading 1 standard lot and the market moved 100 pips against you, then you

would be $1,000 in the red. Not good! If you are not sure what a stop is: it is an

order to close out your trade automatically if the trade goes against you by a 

Bought EUR/USD at 1.3950, and want it to increase in price to profit.

You decided you did not want to risk more than 30 pips on this trade for whatever

reason, so you would place your stop at 1.3920. If the price fell to this level, you would

be automatically closed out of the trade by your broker's platform for a maximum

30 pip loss. It wouldn't matter if you were online or at the beach as it all happens

automatically.

Using stops is a simple part of the whole forex trading experience and an important

one at that. They are easy to place at the start of the trade and easy to adjust once the

trade is up and running. I strongly suggest that you use them at all times to avoid the

unexpected.

Having said all that, certain strategies don’t use stops. However, they

normally have some other mechanism built in to assist with trade management when

the price goes against you. Generally, these types of trading systems are not suitable for

those who are not comfortable trading this way and who do require some further

expertise to be successful. For now, just place a stop on all trades and then you can

   

      A Little More on Risk

Just a couple of points that I have not spoken about.

First up are 'risk' and 'correlation'. I have discussed risk per trade where I suggest no

more than 2-3% per trade. Again, it is up to the individual trader how much they

risk. One thing I must point out though is the problem with correlation. This simply

means that two pairs may trade generally in either the same direction at most times,

or in the opposite direction most times.

The most obvious and highly correlated pairs are the EUR/USD and the USD/CHF

as they move pretty well opposite each other, under normal circumstances.

So if you had bought the EUR/USD on one trade and sold the USD/CHF on another

trade, risking 2% on each trade, in reality, you are risking 4% because of

the high correlation.

The EUR/JPY and GBP/JPY can also move pretty much in the same direction often.

When you think about it, if the pairs have a common currency involved and news

comes out that affects that currency in a big way, then it doesn't matter what

involvement the other currency has, as the market will move the dominant currency.

This is something you will have to be aware of when it comes to total risk on your

trades. The best way to check out how different pairs move about each other

is to throw up the 1hr charts of all the pairs you are interested in trading on the one

screen and see how they move over a few days, especially when news is released.

I also spoke about planned 'news releases' that may or may not move the markets.

Further Discussion about Risk

This subject seems to be never-ending but as already stated, it is very important to

fully understand risk and how it affects your trading. You don't want to blow your

account in one or two stupid trades.

Just going back to my example of only risking

2% on each trade. One thing that does come up, that different people have different

opinions on, is how long you maintain the same position size before adjusting it to

suit your account balance.

Say, for example, you only traded the EUR/USD and your stop was always 30 pips.

You decide your position size, enter the trade and end up making a profit. This will

increase your account balance, and if you were to maintain your 2% risk

on the next trade, then technically your position size would be slightly larger on this

trade. This may not always be possible, depending on your account size and if your

particular broker allows you to trade micro lots you may be forced to round it

down to the previous size anyway.

Now some traders would suggest that you stay on the same position size for a

session, some say the week, and others would suggest a month. No matter what

happens, if you started that particular trading sequence with a 2-lot position size, you

would continue to trade that same 2-lot position size until the end of the sequence,  

   and then readjust it for the next sequence according to your new account balance.

Other traders will suggest you adjust your position size after every trade. This can

get a little confusing, especially if you are trading different currency pairs with

various stops and it can also get a little ugly. Some say this disadvantages you if you

are trying to recover from losses due to the fact you will be entering trades with a

smaller position size if you had a few losses in a row. Not sure about that theory.

As I have said many times, I am trying to keep it simple. I decide on a

position size at the start of my week and I stick with that same position size for the

entire week. Come the following week, I'll have a look at my account balance and

make adjustments if necessary. This works for me and certainly makes my life

easier as the position size is stored automatically in my platform for every trade.

Now some traders may not make that many trades in a week, or they may rattle off

30 trades in a session, so everyone will have their way of doing things. Some

traders will scale in or scale out of trades, which then put another spin on risk etc.

There is no way I can cover all types of trading scenarios, nor do I intend to do so.

This information is just to give you ideas or perhaps make you think of something

you have not previously considered, and then I throw my thoughts in on how I do

things. There is no right or wrong way, and at the end of the day, if you make a

profit and don't get too stressed or worn out doing it, then you are doing something