Risk and Reward in Forex Trading


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This article may well be one of the most important pieces you will ever read as a Forex Trader, if not the most. It’s probably not a coincidence that you landed on this page, wanting to read this article now.

As much as the previous sentence is true, Forex trading does not depend on coincidences or luck, nor on probabilities or as some might say, a calculated guess. If Forex trading relied on probability, then it would be no different to gambling. However, the equation involves a few more aspects which, when used properly, can work in your favor to make trading very profitable.

Prices don’t just rise or fall by themselves nor can you simply rely on their displays or charts to guess the direction before deciding to make a trade and so make a profit – there’s a lot more to it than that!
Having discretionary trading skills is a big advantage for every trader in the financial markets but they can take years to develop. Spotting trade set ups at the right moment during favorable market conditions to gain an advantage and make those trades profitable requires experience and what some traders refer to as a ‘sixth sense’. However, the novice trader can still develop this ‘sense’ and make consistent money by rigidly following the risk and reward principle in Forex trading.
The risk and reward principle by itself has an excellent chance of success. Marry it with self-discipline and emotional control and you’ll have every chance of being a successful and ultimately wealthy trader.

Most people have a basic understanding of risk and reward as it is encountered in many aspects of life, but where it so often fails for people is that they focus on the reward before they consider the risks involved. This happens because of an aspect of basic human nature – greed. How many times have we dreamed of what we’d do with a lottery win before calculating the minuscule chances of us winning it?

Successful proponents of the risk and reward principle always begin the study of their potential trade by considering what they are prepared to risk. Key to this is allowing for a sufficient amount of risk. In Forex trading, placing the stop loss order too close to your entry point doesn’t give the trade much of an opportunity to work out and can increase the likelihood that the trade will close out at a loss and the opportunity would be lost. Using the risk/reward principle will turn the occasional profits you make to consistent profits, and here’s how.

A trader should start by choosing an appropriate stop loss point which marks the amount of acceptable risk for him, measured in ‘x’ amount of pips. He should then calculate reward levels based on multiples of the risk, measured from the entry point. In other words you can set your first ‘profit target’ or take profit level at 1x your risk, 2x or 3x. If you are cautious and look for closing out at reward levels between one and two, you will make good profits even if you lose out on half of your trades. If you close out at two reward levels, you can afford to lose on 65% of your trades and still come out on top!

After setting your stop loss level, based on the difference between your point of entry and the first take profit level at 1x your risk, the second at two times your risk and the third at three times your risk, it’s important to let the trade play out. If you do your homework, the desired result will eventually happen if given enough time. It’s worth mentioning that those who see they are losing on twice as many trades as they are winning often let emotions take over. They are the same ones who intervene in active trades and invariably incur more losses, or take profits too early where the setup has the potential to reach their third profit target and instead settle for half the reward!

Another application of the risk and reward principle that is useful in the context of self-control is the ‘trailing stop’; a risk management technique. Trailing stops are when a trader moves his stop loss level to his entry point when the trade reaches its first profit target, so instead of selling out or closing the trade at the first profit target, a trader ‘trails’ the stop loss. This technique is also used in maximizing profits when a trade reaches its take profit points and expectations still show a continuation in the market behavior or technical oscillators and in the same direction of the trade’s trend. To achieve this, don’t place a pending order for the reward level but trail your stop loss towards the reward level. Many traders do this by a level, each time the price hits a new reward level.

Using the risk/reward strategy combined with a cold, unemotional approach to trading has the potential to make you a very profitable trader.
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