Trading with Candle Charts (Part 4)

07/29/2011 7:00 am EST

Focus: FOREX

This four-part article series concludes with a specific trade example that brings together the main concepts, adding in critical risk and trade management ideas to ultimately generate a nice profit.

Read Part 1, Part 2, and Part 3

So, part of a solid trading plan should include a minimum acceptable risk/reward ratio based on the strategy’s historic winning percentage, for example. The amount of risk (distance between entry and stop loss) will then help determine the appropriate-size trade to place based on a percentage of total trading capital that will be risked per trade.

Let’s assume we entered this short trade just after the doji completed, and the stop-loss order was placed five pips above the high of the completed doji while remembering to then add four pips to account for the spread.

The profit target (T1) might then be placed a few pips (let’s say five for this example) above just above the 38.2% retracement of B to C since this reflects the first level of potential future support based on the most recently established price swing, or trend. (A limit buy order might be placed to automatically take profit at this price level, for example.)

chart
Click to Enlarge

Take an example of a specific currency trade. Short a theoretical ABC/XYZ currency pair (we’ll let you know the actual currency pair momentarily):

  • Stop: 1.0452
  • Entry: 1.0417
  • Limit: 1.0342
  • Total Risk: 35 pips (difference between entry and stop)
  • Total Reward: 75 pips (difference between entry and profit target)
  • Risk/Reward Ratio: 1:2.14 (reward divided by risk)

Assuming the risk/reward ratio is acceptable, you can then determine the appropriate-size trade to place based on your percentage risk per trade as defined by your overall trading plan. As a general rule of thumb, most traders do not risk more than 1%-3% of their total trading capital (1%-3% account balance).

  • Total risk: 35 pips
  • Pip Value: $9.60 USD (approximate pip value at time of this particular exchange rate)
  • Account Balance: $10,000 USD
  • Max Risk per Trade: 2%, or $200 USD

In this scenario, the trader has two options:

  1. Pass on the trade since 35 pips of risk x $9.60 /pip = $336 total risk on trade (over pre-determined $200 max risk per trade)
  2. Adjust lot size to fit within max risk per trade allotment. This would require mini lots. Five mini lots ($4.80 per pip) x 35 pips of risk = $168.00 total risk on trade (within pre-determined max risk per trade)

NEXT: See How This Real Trade Played Out

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Let’s see what actually happened on this particular USD/CHF trade:

chart
Click to Enlarge

This particular trade resulted in a win worth a total of $360 USD. Obviously, this is just one example and in no way suggests or constitutes a standalone trading strategy or methodology. However, the real point here is that profitable trading is not about complex indicators or systems. Above all else is good risk and money management.

If a trader is disciplined enough to only take trades that offer maximum risk/reward ratio, then it’s easy to see that profitable trading is not about being right or winning. It becomes all about the discipline to remain consistent, and to obtain the ability to control your emotions.

This example demonstrates a trade opportunity with just over a 1:2 risk/reward ratio. If that ratio was part of trader’s minimum criteria for placing a trade, then that trader would only need to maintain a 33% winning ratio to break even in terms of profitability. So it is then possible to be profitable over time even when losing more trades than you win.

Understanding this in and of itself gives you an edge or advantage against a majority of traders out there. Let go of your ego, play the numbers game, and you’ll have a good chance of reaching your trading goals.

Now, the market may turn at these predetermined logical profit targets, or in many cases move way beyond them. A trader will never know this information in advance. What tends to happen in the instances where the market continues to move in a profitable direction after the trader has already closed the trade for profit, the “Shoulda, coulda, wouldas” start to take hold, and greed starts to blind the trader to the truth.

The truth is you made a profit, but when the market continues to move in a profitable direction after the trade has been closed, most traders will no longer look at that trade and think “Who cares, I made money on the trade, and I’m happy with that.”

Most traders forget about the profit they’ve taken and start to think, “Damn! I got out too early! Look at how much I could have made (or should be making).” This leads to emotions, and emotions lead to irrational, illogical decisions, especially when money is in the equation. Over time, making trading decisions based on emotion leads to trading suicide (i.e. a zero balance).

In the end, all a trader can do is decide what is logical, understand why those levels are logical, and enter orders accordingly. One of the worst and most destructive habits of nearly all traders is to look back after a trade has completed just to “see what happened.”

By Roger A. Stojsic of GFTForex.com

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