Pips Don't Matter, Money Does

12/21/2015 9:00 am EST

Focus: CURRENCIES

For the benefit of all traders new to the realm of forex, or for all newbie traders for that matter, Ilya Spivak, of DailyFX.com, shares his approach to trade selection and why he believes it is always best to think in terms of money and not pips.

As a longer-term trader, I am frequently asked about how I can stomach risking hundreds of pips on a single trade. I am quick to point out that it is dollars and not pips that truly matter. After all, a 500 pip loss on a 1k EUR/USD position ($50) is far more tolerable than a 50 pip loss on a 100k position ($500). The steady stream of reminders of this basic logic did not help safeguard against a major oversight in my risk management strategy however.

My approach to trade selection begins with cultivating a 6- to 12-month fundamental outlook that informs which currencies I want to be long, which ones I want to short, and which I want to avoid altogether. From there, I use technical analysis to fine-tune entry and exit prices as well as manage risk. Timing was an early pitfall of this approach. I often traded on fundamental hypotheses before the markets gravitated to their realization. This had me stubbornly holding trades that were not working because I believed in the narrative rather than listening to price action.

In the spirit of Yra Harris’ sage advice—“If you’re right at the wrong time, you’re wrong”—I adjusted by introducing a forced take-profit clause into the system. I would take profit on half of any position once the first technical objective was met and trail the stop-loss to breakeven on the rest, allowing it to play out whatever big-picture fundamental theory with risk largely off the table. I also resolved to accept no worse than 1:1 risk/reward on the initial setup on the premise that as long as my process had a positive edge, this would be profitable over the long-term. The problem however, was that I measured the risk/reward ratio in terms of pips rather than dollars.

This was not initially an issue. For example, the system worked great in 2014 when the US dollar trended strongly, making for significant follow-through beyond a trade’s first target. With a 65%-win rate, this generated healthy returns. My ability to pick trades seemingly improved in 2015, with the win rate rising to 73%. Nevertheless, returns suffered, with realized year-to-date gains trailing significantly behind that of the prior period.

Why did this happen? The markets turned choppy in 2015, with many more trades reversing to stop out at breakeven on the second half of a position after booking small gains on the first. So, while the number of losers relative to winners was smaller in 2015 than 2014, their size was on average larger. It was then that I realized what was happening; on a hypothetical 10k trade with a 50 pip stop and a 50 pip first target where I would book half of the position, I was initially risking a dollar loss twice the size of the gain.

The lesson here is simple: it is always best to think in terms of money and not pips. Had I done that initially, the adverse skew in my risk/reward strategy would have surfaced. I have now adjusted my approach to accept no less than 2:1 risk/reward in pip terms. This means that on the same hypothetical 10k trade, the 50-pip stop would need to be matched with a 100-pip first target since profits would only be taken on 5k of the position. This way, a true dollar-based 1:1 risk/reward ratio is achieved, making for a promising strategy if I keep the win rate in the 60-70% range.

By Ilya Spivak, Currency Strategist, DailyFX.com

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