How novice traders can maximise profits and minimise risks
Markos Solomou, Risk Manager from www.easy-forex.com explains some key skills to learn to become a successful forex trader
Let your profits run and cut your losses short is an axiom traders hear a lot. This is much easier said than done. The best way to maximise profit and limit losses is by employing a systematic approach to trading that requires discipline and eliminates emotional decisions.
Most novice traders fail because they often rely on emotions when making trading decisions. Psychology plays a crucial role in trading and, left unchecked, fear and greed make it nearly impossible to make rational trading decisions, increasing the likelihood of failure. Fear may stop a trader from taking a loss. Learning to take a loss is key to becoming a successful trader and the only safeguard for preventing major losses. Greed may lead to overconfidence, encouraging too much risk taking and a breakdown in discipline.
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, require continuing education and learning about the markets.
Setting of goals 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 and avoid major loss of capital.
Money management is a defensive concept and key to the difference between success and failure in trading. An effective money management strategy helps 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 he stands to lose if the trade moves against him, i.e. the risk. A good risk to reward ratio should generally not exceed 3% of capital and have a profit target of 3 to 1. Risk reward ratios are not set in stone and should be adjusted by your level of risk tolerance, current market environment and your trade entry and exit points.
Placement of a stop order is an important part of risk management and should be determined at the time a trade is entered. A stop loss order is a type of order which will help to both limit trading losses and lock in trading profits. Placement of the stop can be based on calculation of how much you plan to risk on 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 riskreward 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 limit risk of large losses.