Chapter 2 Profit and Risk
Each forex trader dreams of winning a good fortune with the smallest risks. In other words, all forex traders are pursing a high risk/reward ratio. But what does that mean? Does high profit always come with high risk?
What is risk/reward ratio?
The risk/reward ratio refers to the potential risk of an investor in proportion to his or her potential profit. For example: If you risk 50 pips on a trade and you set a profit target of 100 pips, then your effective risk to reward ratio for the trade would be 1:2. The risk/reward ratio is used by traders to manage their capital during trading. Usually, an appropriate risk/reward ratio would be 1:3.
Can Low Risk Trading Result in High Profit?
A common perception among the general retail investing and trading public is that in order to garner large profits, you must take on big risk. This view comes from the fact that most people perceive volatility and leverage as high risk. Therefore, if one engages in the markets during periods of high volatility using a leveraged product, the odds are very low (high risk,) but the profits can be huge if things work out. In essence, the belief is that because most people are risk-averse they should settle for only mediocre returns as higher returns are only reserved for those willing to take on higher risks.
Ascertain Your Tolerable Risk Level
Forex is a highly volatile market, and that’s one of the reasons why it attracts people, as high volatility can bring many opportunities. However, the flip side is that high returns also come with high risk. Since Forex brokers allow you to use high leverage (1:400, 1:500, or even 1:2000), your gains or losses can be far more than your actual investment. That’s why you need to identify the risks.
If you are adventurous, you may want to risk 4% to 5% on a single trade. If you find yourself hating risk, then risking 0.5% to 1% isn’t a bad idea. However, professional traders advise that you shouldn’t risk over 2% of your account balance on each trade.
Choose Your Trading Approach
Your trading approach is one of the factors affecting your average returns. Therefore, it’s necessary to identify which trading approach best suits you.
If you are confident enough and have much time to trade, then short-term approach may be suitable for you. Scalping and day trading can bring huge profits if you have a good trading system. Mid-term and short-term approaches often match traders who don’t have much time to trade. In this case, their potential profits can be less than profits from day trading, but their risk also decreases.
Don’t Forget Compounding Gains
The more compounding trading you are doing, the less risks you will be exposed. Your potential profits will be bigger and bigger if the compounding trading system our your own making is created.
Minimize Your Trading Risks
The most advisable methods is to understand all the aspects and terms mentioned above and that involve the world of Forex. With them you will learn the best methods and use rationally the leverage and the margin, avoiding losses and, therefore, potentially increasing your profits.
The second method is stop loss. On this occasion you select a rate that will indicate the loss limit of a specific operation. If the operation reaches that rate, it will stop automatically. In this way, you control your investments and do not lose more than you are willing to pay.
The third method is take profit, which closely resembles stop loss. The difference is that, in this, a profit rate is set that can be modified (while keeping the position open) and allows you to control the negotiation without the need to be regularly observing the possible fluctuations.
