In the last post, I briefly went over how to use leverage in forex trading and more importantly what NOT to do when you are first starting to trade on the foreign markets. In this post, I am going to expound on this by going over the risks of forex trading...most notably how to use a risk versus reward ratio to exploit forex trading and actually not lose your butt in the process.
Do You Understand Your Risk Versus Reward?
I hate to beat a dead horse but understanding risk versus reward is probably one of the biggest (yet untraveled) roads out there and I actually learned how to do this several years ago when I first started doing sports gambling.
The reason why I ask this is because understanding this is paramount to how much money you will want to risk. Establishing and understanding the risk/reward ratios will help you with understanding exactly how much leverage you will want to use. Once you understand this, you will realize that not all trades are created equal. I will repeat this....
NOT ALL FOREX TRADES ARE CREATED EQUAL
One of the first rules that you will need to understand is that when you are making trades, you should always examine the risk/reward ratio. In sports gambling it is no different. You want to find the entry/exit points that will maximize your reward while limiting your risk.
The reason for this is simple. If you can stick to a disciplined plan of attack and know how to maximize your risk/reward ratio, then logic would say that you will come out ahead.
For instance, if you have measured the risk/reward ratio to be 3:1, then you can safely ascertain that all you need to win is 1 trade (with the spread in mind) and lose 2 trades to break even.
So, once again, let's use a real world example....
Let's say that you have found a good forex trade that looks like in all likelihood it will be profitable. All things point to the market moving in the direction that you want it to. Now, you ascertain that the risk/reward is 4:1. You have established that you won't enter a trade that is less than 3:1.
In layman's terms, you are betting that for every trade you make, you only need to win 1 out of 4 to break even (without a spread...it would most likely be 1 out of three with a spread).
Great, you say...but how do you determine what your risk to reward ratio is? What metrics and variables can you use specifically for forex trading?
To understand this, you will need to understand Fibronacci retracement levels. Since you probably haven't gone there yet (assuming you are an amateur forex trader), I will try to explain it in layman's terms.
Basically Fibronacci was this Italian mathematician that published a very important book on calculations. What Fibronacci did was create a series of numbers where if you added 1 (+1) to the previous number, you would get the next number. Here is an example...
1,1,2,3,5,8,13,21 and so on.....
Now if you divided two subsequent numbers on the list, you would get a ratio. The further along you go, the close to phi you get.
For our purposes, the three numbers that are most commonly used in forex trading are .382, .500, and .618.
These numbers will actually help you establish a risk/reward ratio...
So, let's use a real world example....
How I would calculate my risk is by setting point A (which is the highest point) and then point B (which is the lowest point). I would then do the math (or in this case, my trading platform does the math for me) to get the retracement values. I would then go to the risk probability calculator (which is free by the way) and see whether me making the forex trade will be worth the risk.
Hindsight...20/20 right? Sure. You can view this however you want. It is obviously easier for me to look at this after the fact and see that if I had made this trade at the lowest point, I would gain 40 pips if I stopped it at its current point (where the uptrend is seeming to meander). But that is part of the game....doing your homework, finding the trend and capitalizing on the trend.
If you are wrong, so what? You can't win them all but if you constantly temper your trades and only go after the ones with a high risk/reward ratio, then you can buffer the losses.
Oh, and by the way...here is the risk probability calculator for you.
I have rambled on enough for the day. To sum it all up, if you don't understand the risks of forex trading, then you are cheating yourself out of potential good money. If you don't understand how to manage your risk to reward ratio in your forex trades, then you might as well be at the casino betting on red or black. The risks of forex trading are just too high to be playing around with.
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