With trading it is easy to forget the importance of discipline, until it is too late!
If you are considering trading as a career, then your goal will be to create consistency which in turn will offer longevity. Without solid risk management this is impossible and therefore controlling losses and capitalising on winning trades is essential.
Trading is a numbers game. Although, that said, it is essential to only accept high probability trades and let the market come to you rather than you chasing the market! This takes experience and more importantly, patience. One quote I always remember basically states, the markets are a way of transferring money from the impatient to the patient!
As a pro trader, when I am considering a trade and identified my entry price, the first thing I do is calculate where I need to place my stop-loss as then I can assess if I can afford to take the trade on and also what size I should use. Once I have established how much I could lose if I am wrong, I then analyse where the market may reach in my favour, and if this is at least twice as much as the possible loss, then I will take the trade on; if not, I will not execute the trade as my minimum requirement is 2:1 for my risk-reward.
Sometimes I may have to settle for a little less and then other times if I sense there is more profit in the trade, I will move my take profit. Trading requires that element of flexibility.
Winners to loser’s ratio goes hand-in hand with risk-reward. If my risk-reward was only 1:1 then I would need to be right at least 7 out of 10 trades to get any profit, With 2:1 I can afford to be right only half the time and still make money, of course my aim is to hit a higher success rate.
As an example:
- 1:1 (win 5 and lose 5) 5×50 = 250 and 5x-50 = -250, then I would be losing on fees.
- 2:1 (win 5 and lose 5) 5×100 = 500 and 5x-50 = -250 then I still come out ahead by 250 less fees.
- 3:1 (win 5 and lose 5) 5×150 = 750 and 5x-50 = -250 then I will come out ahead by 500 less fees.
This is only based on being right 50% of the time.
If I manage a 70% success rate, then:
- 1:1 (win 7 and lose 3) 7×50 = 350 and 3x-50 = -150, then I would only be ahead 200 less fees.
- 2:1 (win 7 and lose 3) 7×100 = 700 and 3x-50 = -150 then I am ahead by 550 less fees.
- 3:1 (win 7 and lose 3) 7×150 = 1050 and 3x-50 = -150 then I am ahead by 900 less fees.
You will notice the higher the risk-reward ratio along with a higher success rate leads to a considerable increase in profits.
Risk-reward should be a guide rather than set-in-stone as we need to remain flexible and if you feel the market will not provide the perfect ratio, accept less, as other times you will gain more.
It should also be mentioned that investors consider risk with a different approach to traders. As investors trade less frequently and hold on to their positions for weeks, months or years, they focus on percentage drawdown (maximum percentage they will lose from the capital invested) and therefore will be less likely to set a profit target.