In order to be profitable trading the market, you have to look at your trading performance or the feasibility of your trading strategy taking into consideration various factors. These includes, hit rate, risk to reward ratio, leverage and risk management.
The art of not predicting the market
Yes, you heard me right. It is not possible to predict or forecast exactly where the market is going. Is it going to trend up or down or range till eternity? It does not matter. The keyword here is ‘exactly’. You do not have to know precisely where the market is going to profit from it. You just need to be consistent. Heck, you do not even have to be right most of the time in order to come out ahead.
What you can do is trade in the direction of the prevailing trend. There are many ways to do it. You can simply do a visual scan and if price is moving upwards it’s a uptrend, downwards and it’s a downtrend or choppy and its ranging! You can also place a moving average on the chart and if price is trading above, it is a uptrend, trading below and it is a downtrend. Likewise, if it is trading near the moving average and not going far with the moving average line appearing to be horizontal, it is a ranging.
You definitely will not be right every time in gauging the trend or it can switch trend directions almost immediately but unless you can forecast the future, this is to be expected. However, by trading in the direction of the current trend, you can at least increase the probability that you are trading with the trend. You can control the process, but you cannot control the results. Just make sure you are doing the right thing and stop worrying about stuff you cannot change.
High hit rate does not equates to profit
Hit rate is simply the percentage of times you close a winner out of all your trades. For example, out of 10 trades, Trader A bagged a winner 7 times. That would translate to a hit rate of 70%. However, that does not mean Trader A had made a profit overall. He could be trading with a 20 pip take profit level and a 50 pip stop loss. That would mean he made 140 pips on the 7 winners but made a loss of 150 pips on the 3 winners. He will be down by -10 pips.
Or, take Trader B who made 9 losers of 10 pips each but a single winner worth 100 pips. He would still have gotten a net +10 pips profit. His hit rate would be just 10%.
Risk to reward ratio
Risk to reward ratio or RR ratio, is simply how much you risked to try and book a winner. Trader A will be trading a 5:2 ratio and Trader B a 1:10 ratio. Again, on its own, it does not say anything about you profitability. On a statistical level, it is easy to deduce that a higher ratio will naturally reduce your hit rate. It is definitely easier to hit more winners when you take profit at 20 pips and have 50 pips of negative room to move. To be profitable, you will need to obtain a hit rate of at least 72%.
This is how to come up with your break even requirement.
Assuming P as your probability of winning, and therefore, (1-P) as your probability of losing, W as amount of winning pips and L as amount of losing pips. The hit rate you will need to at least break even is calculated as follows.
P = L / (W + L)
The formula is derived as follows:
W(P) – L(1-P) = 0
WP – L + LP = 0
WP + LP = L
P = L / (W + L)
So in the case of Trader A will be 50 / 70 or 0.714, which translates to a minimum 72% hit rate.
Leverage used should be determined by risk management rules
Leverage can give more bang for the buck and amplify your profits. Likewise, it can also help to burn your account into the ground faster with reckless risk taking. The level of leverage to use should be determined by risk management rules and the volatility of the returns your trading strategy or trading plan generates.
As a general thumb of rule, the losses from any one single trade should not exceed more than 5% of your account size. Preferably, it should account for a maximum of 2% only. For example, if you have a $10,000 trading account, it will not be prudent to risk 10% or $1,000 per trade. It will only take 5 losers to reduce your account size to half. Remember to ensure you can survive to trade another day. It would be tragic to be wiped out and have no more capital left for you to take part in profitable trades later. By risking only 2% per trade, it would take 50 losers to run it down to half.
For example, you spotted 2 trading opportunities which would hopefully net you 120 pips by risking 40 pips, and another which could give a possible 30 pips by risking 20 pips respectively. Assuming an account size of $10,000, you should only be risking $200 per trade. This would mean your trading sizes are 50,000 units and 100,000 units for the 2 trades respectively.
Trade 1, if you lost 40 pips at 50,000 units. (0.0040 x 50000 = $200)
Trade 2, if you lost 20 pips at 100,000 units. ( 0.0020 x 100,000 = $200)
This is how you size your trades and normalized the risk across all trading opportunities.
Trading the forex market or any other financial and asset market might not be as simple as simply opening your trading platform and just fire off trades from your hip. But these are just a few simple steps and planning you can do that can greatly increase the odds of winning in your favor.