Understanding Stop Losses

Forex Trading | by ForexCycle.com | Monday, 09 March 2009 00:12 UTC

A proper understanding of stop loss in Forex trading is essential if you want be a winning trader. Good traders will not hesitate to accept defeat and acknowledge that they made a mistake. It is impossible to be right every single time and the sooner you accept this, the sooner you will start minimizing your losses.

Namely, imagine that a trader purchases a stock for the price of 30 dollars, expecting it to rise to 34 dollars, only to see it go down abruptly. Deciding when to sell and when to acknowledge that a mistake has been made is of crucial importance. If the trader sells the stock as soon as its price falls below 29 dollars, the resulting loss would be small. Moreover, minor losses mean that there will still be money to trade on the following day.

Determining the risk and reward ratio prior to assuming a position is obligatory. If we take the above-mentioned case, had the prediction turned out to be right, the trader would have won four points. A wrong prediction would have implied losing one point. This means that the risk and reward ratio in this specific case is four to one.

Now, let us assume that the trader was right in two out of four trades, i.e. fifty percent. That means that the trader won eight points (two times four points) and lost two points (two times one point). This gives us an overall profit of six points and the trader only guessed fifty percent of the trades. Even if the trader was so bad that they were only right in twenty-five percent of the trades, there would still be a profit of one point.

Traders should always maintain a four to one risk and reward ratio. You should never go for a two to one ratio. A two to one ratio means that most likely there is no telling what direction the market will take. Most frequently the market moves sideways and a great number of traders squander their money instead of just refraining from trading.

You can easily check this out for yourself by simulating trades on paper in these market circumstances. The results will show you that you made the right choice not to put your money on those trades. The most important thing to remember is that choosing not to trade and being right is also a way of winning. Being undisciplined with regard to this fact will ultimately result in loss of money.

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