One of the great things about being a DailyFX Course Instructor is that I get to work with people who are making a commitment to improve as traders. One of the things they ask us is what is the difference between a new trader and a professional trader.
Our answer is this:
New traders think about how much money they can make while professional traders think about how much money they can lose.
Allow me to explain. We see many new traders pull up a 5-minute chart and see that the market is moving down and they interpret that as a buy. It can’t go down forever right? So they buy the currency pair, but the market moves against them by 20 pips. The market then reverses and moves up to where they have a 10 pip profit and they lock in before that winner turns into a loser. After all, nobody ever lost money by taking profits. After three winners in a row the trader is up by 30 pips and feeling good about their new career as a trader. That is until the fourth trade when the market moves down 20 pips, then another 20 pips, then as the market moves down another 10 pips, the trader finally exits with a loss of 50 pips. So after four trades, the new trader has won three for a total profit of 30 pips and lost one trade of 50 pips for a total loss of 20 pips. We see many new traders win 75% of their trades only to lose money doing it. This is not what we have in mind.
On the other hand, a professional trader may identify a trade in the direction of the trend as seen on the daily chart and then move down to the 4-hour chart to pinpoint their entry and exit. The first thing they do after having identified their entry is to identify the price where they will place their initial protective stop in order to limit their losses. The initial protective stop is an order they place on the FX Trading Station to get them out of the trade when the market moves against them. Since they know how many pips they are willing to risk on the trade, they also know how many lots they can open to keep the total risk on the trade to 5% of their account balance. If you have an account balance of $2000, you should risk no more than $100 at any one time. They also know that in order to be profitable in the long run they have to make more when they are right than they lose when they are wrong, typically twice as much. They may only win half of their trades, but also may average 50 pips on the losers and average 100 pips on winners. So after four trades, they lose two for a total loss of 100 pips and win two trades for a total gain of 200 pips for a net gain of 100 pips. That’s good trading.
This money management strategy is called a 1:2 risk:reward ratio and is what we in the DailyFX Courses recommend to new traders. For every pip you are willing to risk, you should look for at least two pips in potential profit. I like to think of trading as a coin toss. There is a 50% chance of being right and a 50% chance of being wrong when choosing heads or tails. But if you win $1 when the coin comes up heads and lose $1 when the coin comes up tails, you are not putting yourself in a position to be profitable. However, if you use a 1:2 risk:reward ratio, that means you win $2 when the coin comes up heads and lose only $1 when it comes up tails. Then you would want to flip that coin 24 hours a day as you have the numbers on your side. Even if the coin came up tails three times in a row, there would be no reason to change your approach. You just need to make sure that you do not bet everything on each toss to prepare for those inevitable losing coin flips. This is how a professional trader approaches the market and is one of the main reasons they are consistently profitable. So give yourself a chance as a trader by identifying your risk before you get into a trade and then looking for more in potential profit than you are risking. It does take patience and discipline to stay in a trade for potentially bigger gains, but those are traits that can be well rewarded in trading. Learn to use them as your edge.
Written by Dailyfx.com