Common Mistake: Ignoring Risk/Reward

This part of your trading machine must not be ignored, keeping these risk/reward scales balanced could actually make or break your career as a Forex Trader. Once again I am fully aware that I am not writing down some innovative thoughts here, but just like the rest of my “Common Mistake” articles this is another important piece of your overall trading machine. So let me break this down using a fictional character.

Meet Logical Larry, our friendly subject for this article. Larry surfs around the internet and finds Forex. He finds a broker that supplies him with a demo account and trading software. After loading up his newly installed trading platform he learns the ins and outs of how the software is functioning and starts to analyze the Forex market. Upon first glance he realizes that you only have 2 options, to buy or to sell. So right away Larry understands that he has a 50/50 win/loss ratio if he just picks one like an idiot (sorry Gambling folk but you are not smart).

Not a terrible place start, 50/50, if you were to always target as many pips as you were risking then you would only need to win 6 out of 10 trades to be profitable. Using 20 pips as our figure; 4 x 20 = 80 pips subtracted from 6 x 20 = 120 pips gives you 40 pips of profit even though you just lost 40% of your trades.. Larry goes on to think about what happens if he always tries to win twice as much as he risks. The result of this logical thought process is that you actually only have to win 4 out of 10 trades to be profitable. Based on always targeting 20 pips and always risking 10 pips for this examples sake; 6 x 10 = 60 pips subtracted from  4 x 20 = 80 pips gives you 20 pips of profit even though you just lost 60% of your trades. Larry furthers his thoughts and considers what would happen if he always targeted 30 pips and risked 10 pips. The result is that you would only need to win 3 out of 10 trades to be profitable; 7 x 10 = 70 pips subtracted from 3 x 30 = 90 pips gives you 20 pips profit still, even though you just lost 70% of your trades. Larry concludes that a 1:1 risk/reward should NEVER be ignored even for a second but a 2:1 risk/reward and above looks much more appealing.

Larry is a logical chap though and he now realizes that this is just 1 part of the puzzle to creating the trading machine in his brain that he so desires. He realizes that trading could be a job for life and that he would never have to work for anyone again. He also realizes that he would be able to work from anywhere he wants and understands that this will not be a quick fix. He must now develop a solid trading plan and all this risk/reward theory will simply be part of it.

Yes, yes, this is some very obvious fact that anyone can figure out, but I can tell you that another fact is that not everyone maintains a strict risk/reward policy and plenty of people lose because of it. There are plenty of distractions due to the many parts that make up this brain mounted ultimate trading machine that you seek. Don’t ignore any of the parts and you will be successful because the funny thing is; trading isn’t that tricky AFTER you have all the parts for your machine. Take your time and I will over time be creating articles about each and every part and how you put it all together.