The secret to becoming a successful forex trader is the ability to maximise your gains and minimise your losses. This is easier said than done ! In my 1st month trading forex I won 65% of the trades and yet I somehow managed to lose money !
Obviously my losses were bigger than my wins, a common problem for the new forex trader. The solution was to look more closely at my fx trading style. I was getting out of trades too early and my losses were too high.
Conventional wisdom says that you should not enter a trade unless your potential gain is at least double your potential loss. Thus, your risk/ reward ratio is 1:2. Seems easy enough, but how can the new trader determine what is the potential gain in a trade ?
I use a combination of indicators and logic. Unfortunately there are a myriad of different things we need to consider and these can also vary depending on the time-frame we are trading.
The following are just a few that we might want to consider if we were looking to day trade on smaller time charts (15 minute/ 1 hour) with a 50 pip stop;
1) Average daily range. If the gbp has moved 180 pips so far today and the average daily range is 200 pips, then I would not take the trade if I was expecting price to extend beyond that limit. There are always exceptional days in forex when the movement can be double, but the % likelihood says that 200 is more likely. Therefore to risk 50 pips to win 20 is a no go.
2) If your potential trade is only 30 pips away from previous strong support or resistance, this could be a trend line, a double top/double bottom. A strong psychological level, perhaps $1.50 to the gbp.
3) Equally, fibonacci lines are often areas that price will bounce off, as are pivot points and bollinger bands.
4) Counter trend. More conservative traders will only trade with the trend. Your potential trade has lots of reasons to enter, but the trend is in the opposite direction.
5) Personally I never take a trade if price is near to lots of emas on different time-frames that it has to break; especially the 200 ema. This also depends on the direction of the emas. For example, if I was looking to long a pair and the 200ema was pointing down or even flat I would not take the trade.
However, if price has hit the ema a few times and the ema has now turned up I would be more likely to consider the trade.
In the following example I show you lots of reasons why I would consider buying gbp/usd, but more importantly why I would NOT enter the trade;
Lots of reasons in this chart to NOT enter a long trade
Reasons to consider why we WOULD take the long trade.
Imagine we are watching the chart in real-time on the green candle;
- Price has moved more than the average daily range, but as price is retracing there is a potential gain of 100+ pips back to the 1.5330 area.
- Price has almost double bottomed off yesterdays low and psychological area of 1.5100
- The 5/8 emas have crossed up and price has broken and closed above the 21 and 34 emas.
- If it confirmed a break above the 200ema and the 50% fib I would take the trade (assuming that there is nothing major in the way on other time frames).
Reasons NOT to take the long trade;
Again imagine we are at the illustrated green candle.
- My stop would need to be 70 pips away (below 78.6% fib) and yet price is unlikely to break the 200ema/50% area. Risk 70 pips, potential gain 0. (If price broke and closed above the 200ema and the fib I would take the trade. Put my stop in 1.5160 area. This would give me a risk of approx 50 pips for potential gain 120).
- Price has spiked but failed to break the 200 ema.
- Price has respected fib levels earlier in the day. It stopped 4 times at resistance on 61.8% fib and has now stopped – to the pip – at the 50% fib. Some days price seems to stop at every fib level.
- The trend for the day is down. Often price will pullback to the 50% fib area and then continue back down.
- All the emas are pointing down.
- The bollinger bands have closed through the candle (think of a door being slammed in its face:)
The flip side of this is that the 6+ reasons above to not enter a long (buy) here are perfect reasons
why we should SHORT here !
- Our stop loss need only be 10 pips the other side of the 50% fib and price has already moved 100 pips lower today. Thus our risk reward is 10 to gain 100 pips. Incredible risk reward that does come along quite often. The difficulty here for the novice trader is that as price is going up and everyone seems to be buying, a new trader would be scared to go against the herd.
- Price frequently reverses at a 50% fib level
- All the reasons above for not taking a long !
Result of the short trade
Price stayed below the 200, 55 and 34 ema for 100 pip gain
Here is a great example of a trade that I predicted on twitter in february of this year. This is on the daily jpy/usd.
Price has broken and closed above the 55ema for the 1st time in 6 months
- Price twice broke the 34 ema in this 6 month period, but on both occasions bounced back off the 55 ema. Thus the 55ema can be said to have been in control of price on this pair. Finally price broke above the 55ema and notice how the 34 and 55 emas are rolling over from a steeply downward trend to a potential upwards move.
- The great thing for me with this trade is that in my mind when price breaks the 55ema its next stop is the 200 ema (top arrow) which was 600 pips away.
- Risk reward was brilliant. My stop only needed to be some 60 pips just below the 55ema. Hey it held price down for 6 months, no reason to think it would not be equally difficult to break back down: resistance becomes support.
So what happened ?
Price stopped to the pip at the 200ema on the DAILY chart !
Many cynics think that technical trading is just mumbo jumbo ( I used to think the same), but this move was logical and predicatable for me. Also note how price struggled for the following 10 days or so at this 200 ema area.
Unfortunately, despite my brilliant prediction ! I only managed about 250 of the potential 600 pips as I moved my stop too near (twice), but that is a different story.
I hope this gives you insight as to what to look for when taking a trade and the importance of having a risk reward ratio of at least 1:2.
if you have any questions re this article please post them here on the blog
Dear Marc,
thanks for the article and examples. Very interesting samples. More interesting considerations.
As to the “I only managed about 250 of the potential 600 pips” – you achieved the first main goal – save ALL your money by removing all risks. Then another big goal – you did a PROFIT. Never mind the missed profits. This is “if I knew” afterwards. By the time you did it, you did it the best way you could.
Example? One day I had some trades open. No profit yet but great opportunity – markets just about break out. I knew they would do at least 100 pips per trade. But all of sudden my child got sick badly – I had to go to a doctor immediately. I closed the trades for safety reasons. The prices indeed did what I had expected, even more.
Did I do it wrong? Not at all – by the time I closed them, all I knew was I must protect my capital first, while the profit was just a prediction. Just imagine some hot news came moving the trades against me?
Anyway, I used to believe in 2:1 Reward/Risk when I traded stocks. Very usable. But Forex is quite different beast.
I will come sooner or later. Just make sure you’ll be there 
)
In stocks, you would consider end of a pullback when price retraces to 68.1% Fib level. In Forex it may be as much as 38.2% or even down to 0%. Why? Because a stock has a single value of a share while a currency pair has two values: each currency it’s own. The market you trade is the balance between the two values. Not alike the stocks.
In Forex 1:1 may be hard to achieve in sideways. It’s a big success if you can get to previous top or bottom. Why? Because in general, initial movement is abrupt and consumes about 75% of what you’d expect. Pullbacks are shallow and all you have left is 20-25% left of the whole move: 7-12 pips for example. Small profits, high risk – take the money and run.
You should NEVER take a trade when you profit is considerably lower than the risk. 1:2 Reward/Risk (risk 20, expect 10) is not an option – if you loose one trade you need two winners just to cover the loss. And how are you going to ensure the next two trades will be indeed profitable?
If you can’t do it or don’t feel it – just don’t do it. Maybe after couple of hours or the next day you’ll find a better opportunity? Back to the beginning: Forex is full of opportunities. Don’t cry about missed one, look for another one
Sometimes it’s like fishing. Wait, wait and nothing for a whole day. But unlike the the real fishing, you look for a “fish” with $$$ bill attached
BTW: I developed automatic strategy that hits 90% accuracy most of the time. Unfortunately it gets 10 pips profits against 90 pips looses on average. In other words – it trades a lot but equity doesn’t really move upwards.
90% accuracy GREAT! But small profits against big looses: 9-10 winners cover one looser. Hundreds trades a day. Would you buy it? Your broker would be more than happy…
Marc, Im not sure if it is the Broker that I use (forex.com) But for some reason it will not let me open 2 lots at a time and then bank pips and move my stop. Do you suggest I use another broker or am I just not doing it right?
hi khalif. if you place pending (future) orders on any system then you can place as many orders as you like. If you are getting in immediately (instant execution) then you have to do them one at a time
One of methods to find good Risk Reward entry – suppose you see buying opportunity:
- find the nearest good support to place Stop Loss at,
If you price is out of the zone – wait for another trade opportunity.
- find your nearest Target Profit – possibly the closest strong resistance, previous top etc.
- Now: your buying zone is everything between the Stop Loss plus half of the Stop Loss to the Target Profit distance. The closest to the SL, the better
Hello, can you please post some more information on this topic? I would like to read more.
Hi garry. More articles re money management risk reward etc can be found on the free lessons on the main site , marc
Damn – the Stop Loss – I had very good GBPUSD position, just after breakout. I could have do at least 100 pip only on this. And guess what? I moved Stop Loss to reduce some of my risk. I used all my wisodm and tools to make room for any additional pullback. And it proved to be too tight by… FOUR pips. I lost 25 pips, price went back and did the 100 without me.
Hey, I just LMT has poor Risk Reward ratio, yet it’s powerful profit collector.
How could it be?
On average, H4 signal is aiming at 25 pips risking 50 on EURUSD for example. This is very poor 2:1. It means if you lose one, you need two winners just to cover one loss. Similar on Daily and other pairs.
So how could this system produce profits?
This is it’s win/lose ratio that changes everything. Dean says it wins 87%. It can be even more but let’s stay simple 80% figure.
We take 10 trades, 8 wins, 3 loses. 8 gain 25 per trade, 3 gives back 50 per trade, 200 pips in, 100 pips out = 100 pips profit net.
You can calculate it other way: Risk: 50 pips *30%, Reward: 25 pips *80%. This gives 15/20 which is 1:166. Much better than common 1:1.
And this is just very conservative figure. I found, about 80% of trades hit first Fibonacci extension = Initial Target*1.618 = 40 pips in this example. About 25% does much more while the risk remains untouched.
But keep in mind: this works on statistics, it will only work if you follow strict money management. You have to balance your trades. If you take too much, one loss can be devastating on your account. Don’t be greedy, be systematic. Allow loses on single trades, but collect winners on most of the trades. Your equity will grow over time.
The secret of my 869 pips day was simple: I was taking trades on two lots, one aiming Initial Target, the other Initial Target*1.618 pips and I didn’t allow to take too much crosses against the same currency, e.g. USD. I played statistics and this made my day
Oops, error in calculations,
It should read:
You can calculate it other way: Risk: 50 pips *20%, Reward: 25 pips *80%. This gives 10/20 which is the perfect 1:2!
Whats up! I simply wish to give an enormous thumbs up for the great information you have got here on this post. I can be coming again to your weblog for more soon.Regards Nick