Aside from steady emotions, what makes a trader profitable? The answer is good money management skills. But not a lot of traders pay attention to it because it can be a fussy process. Nevertheless, it’s crucial to understand it to make money consistently. This article will cover two common forex money management strategies: risk per trade and reward to risk ratio.
The first part of this article talks about the common terms in money management, and if you’re already familiar with these, you can skip ahead to the money management strategies section.
Money Management Terms
What is Stop-loss?
Stop-loss is an order you place on your trading platform to automatically stop your trade from incurring a larger loss.
However, a stop-loss isn’t just for ending losing trades exclusively.
You can also use it for trades that are on the profit side to lock in the gains once the trade goes against you, and that’s called a Trailing Stop-Loss.
What is Take Profit?
A take profit order works the same way as a stop-loss, but the only difference is the take profit terminates your trade from gaining more profits.
Now you may wonder why anyone would want to stop profitable trades, and the answer is take profit orders are best for trades with a predefined target.
Some traders understand that the market rarely goes in one direction uninterruptedly. There will be periods when buyers take a break from buying, and sellers pause from selling, allowing the prevailing price direction to slightly falter.
Take profit orders capitalize on that market observation and bets on the probability that locking in profits at a certain level is better than seeing a trade conclude with either a loss or a less significant gain.
What is Breakeven in Forex?
Breakeven is one of the common trading terms you’ll hear, and it only means that a trade ended with neither loss nor profit.
A trade that reaches breakeven could be a result of a stop-loss that is moved to the opening price.
What is Risk Per Trade?
Risk per trade is the percentage of your account’s equity that will be exposed to the market.
For example, your account is $10,000, and your risk per trade is 1%. This means that you’ll only risk $100 for every trade.
Again, a stop-loss can be utilized to set the risk per trade.
What is the Reward-to-Risk Ratio?
Simply put, the reward-to-risk ratio tells you what you’ll be gaining relevant to the risk you’ll take. You can set this by using take profit and stop-loss orders. Or, you can close your trade based on what you see on the chart.
It is important that you understand what reward-to-risk ratio is and the risk per trade as these will be the main components for devising a money management strategy.
Money Management Strategies
Now, once you’re familiar with the terms, you’ll be able to understand these common money management rules.
1% to 2% Risk Per Trade
A safe percentage of your capital that you can risk per trade is between 1% to 2%. With a 1% risk per trade, it would take a long time before you get knocked out of the market.
Assuming that you get 100 losing trades consecutively — if that’s even likely — you’ll still have 37% of your capital with a 1% risk per trade.
On the other hand, if you risk 15% per trade, for example, you’ll be down to 5% of your total capital after only 20 trades.
Target a higher reward
Aside from understanding how much you’ll risk per trade, you need to set your eyes on how much profits you’ll be targeting — and, it has to make sense mathematically.
There are two ways to be profitable:
- A strategy with a 1:1 reward to risk ratio but with a high win rate
- A strategy with a decent win rate but with a higher reward profit target relative to risk
So, the strategy with an even reward to risk ratio will only be profitable if you win more times than you lose.
And, the strategy with a decent win rate can lose more often than win and still be profitable if the profit target is at least twice the risk.
Check the table below:
This is the strategy with a reward to risk ratio of 1:1 and in 10 trades with equal wins and losses, no matter the sequence of the +1% gain and the -1%, the result after the 10th trade is always the same — $9995.00 or a -0.05% loss.
However, if the trade wins 70% of the time with a 1:2 reward to risk ratio, the account becomes profitable after 10 trades despite taking in twice the risk.
Finally, a strategy that doesn’t have a high win rate but has at least a 2:1 reward to risk ratio can still be profitable. The image below shows a strategy with a 40% win rate with a 2% gain for each winning trade, and the result is a 1.91% gain after 10 trades.
And, of course, some strategies may work 20% to 30% of the time, but if it targets a reward five times the risk, then it would still make a profit. One example of that is the MACD crossover strategy.
Making use of the stop-loss to manage risk
The essence of a stop-loss is to set your risk automatically so that no matter what happens, you don’t incur a loss higher than your intended risk per trade.
Stop-loss can be preset orders, or it can be dictated purely by technicals. If you just started trading, it’s best to set stop-loss orders rather than pick a spot in the chart where you’ll close a trade.
When you haven’t mastered how your strategy works, your emotions may take over, and you’ll be less inclined to accept a losing trade.
How to set risk with stop-loss
Here are the steps for you to set risk using stop-loss:
- Determine the number of pips you’d risk losing from your trade entry.
- Determine what your risk per trade will be.
- Multiply your account balance to the risk per trade and divide it to the number of pips, and you’ll get the per pip value.
- Lastly, divide the per pip value to 0.0001 (if it’s not a YEN pair), and you’d get the lot size needed.
Example: You have a $10,000 account with a 1% risk per trade and 50 pip risk.
- $10,000 x 0.01 = $10
- $10 ÷ 50 pips = $0.2 per pip value
- $0.2 ÷ 0.0001 = 2000 units or 2 micro lots
So, in this example, once your trade goes 50 pips against you, you’ll only risk $10 from your account.
Do you want to know how you can convert the pips gained in USD to another currency? Read this article.
To recap, you’ve learned five terms that are necessary for money management: stop-loss, take profit, breakeven, risk per trade, and reward to risk ratio.
You’ve discovered why it’s necessary to have a profit target that is higher than your risk.
You also read two concepts to profit from trading forex.
And, lastly, you’ve learned how you can use the stop-loss to set your risk.