“Let your profits run and cut your losses short”. This is an axiom traders hear a lot, but it is much easier said than done. The best way to maximise profit and limit losses is to employ a systematic approach to trading that requires discipline and eliminates emotional decisions.
To succeed, you must treat trading like a business and, to make money, learn how to manage risk.
The first step to maximising profit and limiting loss is to create a trading plan that includes a money management strategy. Money management is risk management and is used to deploy and preserve risk capital and keep you in the game.
At a minimum, a trading plan should include a set of goals, a money management strategy that seeks capital preservation, and guidelines for disciplined trading decisions. The plan should also set risk/reward ratios, have tools for determining where to place stop losses and profit targets, and make provision for continuing education and learning about the markets.
When setting the goals in your trading plan you should include questions as to why you are trading and what you want from trading. If you don't know what you want, the markets can be an expensive place to learn. Some people may trade for the excitement or the competition, others may trade as a hobby, but most often the goal is to make money while avoiding major loss of capital.
Money management is a defensive concept which is key to the difference between success and failure in trading. An effective money management strategy helps to set rules for how much to risk per trade and has two basic controls - discipline and capital preservation.
The amount of risk per trade is usually determined by a risk/reward ratio. The risk/reward ratio is defined as expected risk on a trade compared to expected return. The ratio is calculated by dividing the amount of profit the trader expects, i.e. the reward, by the amount they stand to lose if the trade moves against them, i.e. the risk. A good risk/reward ratio should generally not exceed 3% of capital and have a profit target of 3 to 1. Risk/reward ratios are not permanently fixed and should be adjusted regularly by your level of risk tolerance, the current market environment and your trade entry and exit points.
Placing a stop loss order is an important part of risk management and should be done at the time of entering a trade. A stop loss order is a type of order which will help both to limit trading losses and to lock in trading profits. You can decide where to place the stop by calculating how much you plan to risk on a trade, a breakeven point, or by using tools like technical analysis. A trailing stop is used to protect profit or exit a market once a profit target has been reached. Most often, profit targets are determined by the risk/reward ratio. As a general rule, the longer you stay in a trade, the greater the risk.
For the novice trader, reducing position size, lowering the risk/reward ratio and shortening the duration of a trade are good ways to preserve capital. This is important because trading often involves drawdowns of capital. The goal is to use risk management to withstand these periods of drawdowns and thereby limit the risk of large losses.
written by Markos Solomou, Risk Manager at www.easy-forex.com, highlights key skills that can help you become a successful forex trader.
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