Managing Risk & Reward

In this lesson we will examine:

– Components of a successful trading methodology
– Understanding risk:reward ratios and what it means to your trading
– Why risk management is crucial in trading

Risk management is one of the most important components of successful trading. Even the best traders in the world suffer losing trades – indeed, some of them lose more often than they win! But in order to remain profitable, proper risk and money management is key to surviving in the markets.

Risk management rules are easy to understand – even for beginners – but they can be challenging to actually follow, because the emotions of fear and greed can overwhelm traders when real money is at stake.

Before we move onto specific risk management techniques, let’s look at how money management makes up a crucial element of a successful trading strategy and overall methodology.

Successful Trading Methodology

Successful traders do everything they can to put the odds firmly in their favour when entering trades.

In addition to a trading strategy, the best traders also use the following techniques to develop an overall methodology – bringing together all the components of trading and doing their best to be disciplined in all areas, from risk management to dealing their emotions.

These factors now follow.

Trading System Edge

In order to be profitable, a trading system/strategy must have something that traders refer to as an “edge”. An edge simply means that the system has a statistical probability of having more profitable trades than losing ones.

Just having a profitable system is not enough though. The rules of the system must be consistently applied. For example, if a system has strict entry and exit criteria, then these should be adhered to at all times.

Risk:Reward Ratios

The below table shows the required risk:reward ratio required to achieve breakeven (i.e. trade and show neither a profit or loss on the trading account).

This is important to know when calculating a trading edge, since any improvement on the above risk:reward ratio will mean a positive expectancy on the account, meaning the account is in profit.

It is also important to be aware of this information so you have realistic expectations about your trading.

A risk:reward ratio of 1:2 means your profit target is double that of your stoploss, whereas a risk:reward ratio of 2:1 means your stoploss is twice the size of your profit target.

Using the table above, some traders, particularly scalpers, try and have a very high win rate. They may have very small profit targets and either very large stop losses, or no stop losses at all. Despite the high win rate, the statistical 20% losing rate will wipe out all the gains if their risk:reward ratio is 4:1.

On the other hand, a position trader that wins only 20% of the time, but has a risk:reward ratio of 1:4, will achieve breakeven despite the 80% loss rate.

Most successful trend traders only win between 35-45% of the time, but using a risk:reward ratio of 1:2 (or better) means that they are profitable.

It’s important to focus more on your trading system, overall methodology and your risk:reward ratio than to worry about the percentage of losing trades.

Emotions & Discipline

Fear and greed drive financial markets. Once you have entered a trade, you may find yourself panicking – getting out of a trade too early, moving your stop loss because the market is going against you (resulting in bigger losses than you intended when you placed the trade) and “revenge trading” – aggressively scalping because the trade went against you.

It’s also possible for traders to “get bored” and start placing speculative trades, thinking “it’s only a few pounds, I’ll just play around”. Needless to say, this behaviour more closely resembles gambling, and can quickly lead to a depleted trading account.

If you have analyzed your trade carefully, set a stop loss, take profit and perhaps a trailing stop, one of the best things you can do is simply turn off your monitor and do something else. This way, you won’t be tempted to “fiddle” or “manage” the trade. You can come back later to see the outcome and analyze and record what went right or wrong if you keep a trade journal.

Keeping a Trade Journal

A trade journal is a record of trades you have made. You can keep all sorts of information in a journal but one of the key reasons that so many professional traders keep one is for accountability. By honestly recording whether you stuck to the rules of your trade methodology, you can prevent yourself from taking shortcuts and making mistakes. You may also start to notice patterns in trades that could improve your trading system.

In trading, you are your own boss, so having accountability to yourself is extremely important.

Not all traders keep journals, but if you feel like you need some additional discipline, then you should definitely consider keeping one.

Money Management

Proper money management is a crucial part of your strategy that specifies the size of the position, the amount of leverage used and your stoploss and take profit levels. Good money management maximises profits, minimises losses and prevents you from taking on too much risk.

Most successful traders risk between 0.5-2% of their trade account balance per trade.

This percentage is then divided by the number of pips or points (for CFDs) used for the stoploss.

Let’s assume you have £5,000 in your trading account, and you wish to place a trade on GBPUSD with a 50 pip stop loss, risking 1.5% of your trading account:

You position size = the total account percentage you are risking / (stoploss * value per pip)

Therefore:

– The amount you’re risking = 1.5% of £5,000 = £75
– Value per pip for 1 standard lot = £10/pip
– Stop loss = 50 pips

Position size = 75 (total risk in money) / (50 (stop loss value) *10 (pip value)

= 0.15 lots (or 15 micro lots)

Assuming this trade won, you would have made £150 and increased your account by 3% (less spread and commission).

Assuming this trade lost, you would have lost £75 and decreased your account by 1.5% (plus spread and commission).

Things become slightly more complicated when you factor in currency conversions into other currencies. For example if you want to trade the EUR/USD, you would need to first convert Pound Sterling into Euros (the base currency) to arrive at the correct pip value. You can easily do this using a Position Size Calculator.

You can find one on the MyFXBook website: MyFXBook Position Size Calculator

(Please note, we are not responsible for content on third-party websites)

Finally, by risking a fixed percentage per trade, assuming your trading system is profitable, you will benefit from your account growing via compounding – the larger your account grows, the bigger your position size becomes.