How to Do It: Follow One Simple Rule

Avoiding the loss-making problem described above is pretty simple. When trading, always follow one simple rule: always seek a bigger reward than the loss you are risking. This is a valuable piece of advice that can be found in almost every trading book. Typically, this is called a “risk/reward ratio”. If you risk losing the same number of pips as you hope to gain, then your risk/reward ratio is 1-to-1 (sometimes written 1:1). If you target a profit of 80 pips with a risk of 40 pips, then you have a 1:2 risk/reward ratio. If you follow this simple rule, you can be right on the direction of only half of your trades and still make money because you will earn more profits on your winning trades than losses on your losing trades.

What ratio should you use? It depends on the type of trade you are making. You should always use a minimum 1:1 ratio. That way, if you are right only half the time, you will at least break even. Generally, with high probability trading strategies, such as range trading strategies, you will want to use a lower ratio, perhaps between 1:1 and 1:2. For lower probability trades, such as trend trading strategies, a higher risk/reward ratio is recommended, such as 1:2, 1:3, or even 1:4. Remember, the higher the risk/reward ratio you choose, the less often you need to correctly predict market direction in order to make money trading.

Stick to Your Plan: Use Stops and Limits

Once you have a trading plan that uses a proper risk/reward ratio, the next challenge is to stick to the plan. Remember, it is natural for humans to want to hold on to losses and take profits early, but it makes for bad trading. We must overcome this natural tendency and remove our emotions from trading. The best way to do this is to set up your trade with Stop-Loss and Limit orders from the beginning. This will allow you to use the proper risk/reward ratio (1:1 or higher) from the outset, and to stick to it. Once you set them, don’t touch them (One exception: you can move your stop in your favor to lock in profits as the market moves in your favor).

Managing your risk in this way is a part of what many traders call “money management”. Many of the most successful forex traders are right about the market’s direction less than half the time. Since they practice good money management, they cut their losses quickly and let their profits run, so they are still profitable in their overall trading.