Risk is part of every job, even the simplest one. In other words, risk is inevitable, no matter what your job, profession, or business is. The only thing you can do is try to control it.
In Forex, we don’t trade certainties but probabilities. The key is to focus on risk-reward setups and make trades that have a better risk to reward ratio.
How To Assess Risks and Rewards?
The best method to assess risks and rewards is to maintain a Risk Management Chart. This is based on analyzing the risk-reward levels involved in each trade. In this method, you calculate the rewards as a multiple of risk, which will constantly remind you about the risks involved in every trade, preventing you from executing a trade on impulse.
Look at the chart below. There are 10 trades in total. The risk to reward ratio is set as 1:2, and $100 is considered as profit/loss in every trade.
|RISK MANAGEMENT CHART (1:2)|
|S. No.||Win||Loss||Net P/L|
Now, in the first case above, if you win 6 trades and lose 4 trades, you stand to get 6 x $100 = $600 as your profit and 4 x $100 as your loss, thus giving you a net profit of $800.
If you calculate in this manner, you can still make a $200 profit even if you lose 60% of your trades and win only 40% of them!! The only time you suffer loss would be when you lose 70% or more of the trades that you make.
Now let us take another case where you set your risk-reward at 1:3. In this case, the chart will look slightly different as shown below:
|RISK MANAGEMENT CHART (1:3)|
|S. No.||Win||Loss||Net P/L|
As you can see, if you set the risk-reward at 1:3, then even if you lose 70% of your trades, you still can earn a profit of $200.
However, a risk-reward analysis will not yield optimum results if you don’t have a concrete trading strategy. So the first step is to formulate a trading strategy. This can be a price action strategy or any other form of Forex trading strategy.
The second step is to decide the risk-reward ratio. This should be determined based on the strategy that you have laid out in the previous step. It can be 1:1, 1:2, or even 1:3. If you keep the ratio at 1:1, then you would have to win many more trades to neutralize the losses and close the day with a decent profit. Hence, it’s always better to set the ratio at 1:2 or 1:3. When you apply that kind of risk-reward analysis to your strategies, you can trade without unnecessary setbacks.
This method of risk management, using a risk-reward chart, can be used in conjunction with other strategies as well. It can be used along with price action charts, money management principles, trading bad news, and so on. Though the basic principle remains the same, the method of application differs slightly in all these cases.
One of the main advantages of this method is that it fixes the emotional side of trading. Traders tend to get overconfident with every winning trade and hesitant with every losing trade. This method of risk-reward analysis helps the trader be a lot more objective and be less affected by previous trading results.
A crucial point: to take full advantage of this method, you have to be patient enough to execute a large number of trades. Consistency is the name of the game. And for that, you have to complete a good number of trades. So, if you run out of patience and stop midway through, then it may not yield the expected benefits. This is because we are looking at the overall profit and not on individual trading result. Therefore, unwavering focus and patience are essential prerequisites to use the risk-reward method successfully.
It’s all about bringing probabilities under your odds. This is certainly achievable if you put coordinated efforts with patience by combining risk-reward analysis with other trading strategies.