Money management and risk-to-reward ratios

Money management is arguably the most important concept that a trader needs to master in Forex. Strict money management rules, such as using Stop Loss levels, managing the risk per trade, risk-to-reward ratios, and position sizes, need to be rigorously followed by all traders who are serious about being successful in the long run. Even the best trading strategy in the world won’t be of much help without sound money and risk management practices, making this one of the first lessons that newcomers to the market should learn.

Money management is the way you manage and oversee the risk of your trades in order to increase your profitability. We’ll cover the main aspects of money management in this article, including risk-to-reward ratios, risk per trade, drawdown and maximum drawdown on your trading account, position sizing, and more. Make sure that you’ve understood all these concepts before moving on as they will form the cornerstone of your trading career.

Keep an eye on the risk-to-reward ratio of your trades

The first concept you need to learn in order to master money management is the risk-to-reward ratio of trades. The risk-to-reward ratio is simply the ratio of your risk relative to the potential profit of a trade. At the time you enter a trade, you should know in advance at which price levels you intend to exit the market, and place your Stop Loss and Take Profit orders accordingly.

Your exit targets also determine the risk-to-reward ratio of the trade. For example, if you place your Stop Loss 50 pips below the entry price, and your Take Profit 100 pips above the entry price for a long position, the risk-to-reward ratio of your trade is 2:1. On the other hand, if both your Stop Loss and Take Profit order are set 50 pips away from the entry price, the risk-to-reward ratio of your trade is 1:1.

While risk-to-reward ratios of 1:1 mean that you’re risking the same amount as the potential gain of the trade, risk-to-reward ratios of 2:1, 3:1, or more mean that the potential gain is two or three times higher than the risk of the trade.

It’s important to note that when you take trades with higher R/R ratios, you can have more losing trades than winning ones and still break even. In fact, having two losing trades and just one winning trade with risk-to-reward ratios of 3:1 will leave you with a profit.

The following chart shows what a trade would look like with R/R ratios of 1:1, 2:1, and 3:1.

pic.1

Although it’s more profitable to make trades with higher risk-to-reward ratios, you should still place your Take Profit orders with reasonable expectations. Obviously, the price needs more time to hit a Take Profit level that is far away from the entry price, or it could even miss the target and reverse, leaving you with a loss rather than a profit. Also bear in mind that price targets of 100 pips or more may need a few days to get hit, as opposed to targets of a few dozen pips which are often reached during the course of intraday trading.

In addition, as risk-to-reward ratios are a numbers game, you will tend to see their main benefits over a larger number of trades. For example, making 20 trades with an R/R ratio of 3:1 and a trading strategy that is profitable 50% of the time should essentially leave you with 10 winning trades and 10 losing trades. As the winning trades are three times larger than the losing ones, you’ll end up with a nice profit.

Know your risk per trade and stick to it

Aside from the risk-to-reward ratio of trades, there is another important concept in money management – the risk per trade. As the name implies, your risk per trade is the maximum amount you’re willing to risk as a percentage of your trading account balance.

The golden rule of money management is to never risk more than 1-2% of your trading account on a single trade depending on the probability of the trade setup. Moreover, the risk of all open trades combined should not exceed 5% of your total trading account balance. If you’re new to the market, you should stick to a risk per trade of 1% or lower until you get more familiar with the various concepts and trading tools available.

This rule gives you enough room to steadily increase your account balance without having to worry about a streak of losing trades. The maximum you’ll lose on any single trade is 1-2% of your account balance.

Beginners on the market often make the major mistake of risking too much on single trades, which often leads to losses that decrease their account balance by a large amount of money. It may be very painful to get back to your initial balance once you lose 40% or 50% of your account. In fact, after you lose 50% of your account, you’ll need to make a whopping 100% profit just to break even! Don’t underestimate the power of risk, as less than 1% of traders worldwide are able to double their account balance within a reasonable amount of time.

Amount of balance lost

Amount needed to return to initial balance

10%

11%

25%

33%

50%

100%

75%

400%

90%

1,000%

Drawdown and maximum drawdown explained

Without a strict money management policy, traders often suffer large drawdowns on their accounts. While drawdown is normal in trading - no one can have winning trades 100% of the time - it may be a lot more difficult to recover from a larger drawdown than a smaller one.

Drawdown is simply the reduction of your trading account balance after a losing trade or a series of losses, presented in percentage terms. It’s the distance from the most recent peak in your balance to the most recent trough. The maximum drawdown, on the other hand, is the distance from the highest peak to the lowest subsequent trough in your balance history. The picture below explains the difference between drawdown and maximum drawdown.

pic.2

How to determine the right position size for your trade

In the context of this article, the concept of position sizing refers to the maximum position size you can take to remain inside your risk per trade boundaries. Just like determining risk-to-reward ratios and the risk per trade, position sizing should be used on all your trades, which we’ll now show you how to do in three simple steps:

Step 1: Set your Stop Loss based on market conditions. Once you spot a trading opportunity, determine where to put your Stop Loss based on recent price action. This can be at zones of major support and resistances, trend lines, or recent swing highs and lows. Let’s say your Stop Loss level is 50 pips away from your entry price.

Step 2: Calculate your risk per trade. After you’ve decided where to place your Stop Loss order, it’s time to determine your position size. First of all, you should calculate your risk per trade based on the 1% rule. Let’s say your trading account balance is 10,000 USD. One percent of 10,000 USD is 100 USD, which means that your maximum risk per trade should not exceed 100 USD.

Step 3: Determine your position size. Now that you know your Stop Loss level and risk per trade, it’s straightforward to determine your position size. Simply divide your risk per trade and Stop Loss in pips to get the dollar-value of a pip for your position size. In our example, 100 / 50 gives us a position size of 2 USD per pip, i.e. approximately 0.2 lots.

pic.3

NOTE: Your position size, not your Stop Loss level, will determine the amount of dollars you’re risking on a single trade. You need to adjust your position size, and not your Stop Loss, in order to stay within your preferred risk per trade!

Chart stops vs. fixed $ stops

As you noticed in the section about position sizing, we used the term “…Stop Loss based on market conditions” under step 1. This is very important to make clear now, as there are four main types of Stop Loss orders you can use (but shouldn’t).

These are:

  1. Percentage stops – these stops are set as a predetermined percentage of your trading account balance. While this may require fewer steps than position sizing, it’s not recommended for a well-rounded money management strategy. Your risk per trade should be determined by your position size, not the Stop Loss.
  2. Volatility stops – volatility stops are based on the average price volatility of a currency pair. While it does sound logical to take the volatility of a currency pair into account, it should not be the only factor in determining the level of your Stop Loss order. After all, volatility may change at a moment’s notice during major news releases or other market irregularities.
  3. Time stops – as their name implies, time stops are based on time. Examples of time stops are closing the position after the NY session ends, at the end of the trading day, or just before the weekend. Again, these types of stops don’t take price action into account and don’t add any real value to your money management strategy.
  4. Chart stops – chart stops are the types of Stop Loss orders you want to use. They are based on real market conditions and price action, and take into account the current market environment in which you’re trading. Chart stops can be placed on recent swing highs or lows, support and resistance lines, above or below chart patterns, or at any other price level which is in line with your preferred trading strategy.

NOTE: It’s important to use Stop Loss orders on all your trades! They are your main insurance against losing your entire account balance on a single trade.

Use leverage with caution

As a final note about money management, let’s talk about leverage in trading. Most Forex traders are familiar with leverage, and many new traders are attracted to the Forex market in the first place because of the high leverage offered by brokers. Currency pairs often move less than 1% a day, making leverage a handy tool to magnify your profits.

Keep in mind, however, that higher leverage also implies higher risk, as both your profits and losses are magnified by the same amount. However, if you correctly utilise all the concepts mentioned in this article, you should be able to manage your losses and risk in a disciplined way and grow your trading account in the long run. Furthermore, if you’re a beginner, stick to lower leverage or use a demo account until you get more familiar with trading.

Conclusion

Just like trading on any other financial market, the most important lesson in Forex trading is to learn how to effectively manage your money and risk. This is done by having a strict money management policy, which should ideally be written down. This way, you’ll have all your rules in one place, which should help you avoid emotional trading and losing larger sums of money.

Effective money management is achieved through concepts such as risk-to-reward ratios, risk per trade, keeping track of your account drawdown, determining the right position size and setting appropriate Stop Loss levels based on current market conditions. Finally, always calculate your position size based on your Stop Loss level in pips, and avoid using volatility stops, percentage stops, and time stops in your trading. This will help you gain a major advantage over other traders with poor money management guidelines.

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