Well it’s 2016, and another year has gone by. New Years resolutions have begun, gym memberships are sky rocketing and everyone is motivated to become more fit, drop a bad habit, pick-up a new hobby, or set new budgets. Although I have never been convinced that the dawn of a new year gives you any advantage of actually accomplishing any goal, what I do believe is that by writing out your goal on paper and establishing a date, will give you a much better chance of completing it.
One thing I have looked at for myself in the past couple years is a specific Money Management philosophy in my trading. At the end of each year, I take stock of how well (or horribly) I have traded for the year and make sure that my strategy is sound and still valid. This is an exercise I wish I learned my first day trading because it would have not only made me more money, but it would have substantially mitigated a good percent of my total losses in my first year. So what I am going to share with you now is a very simple philosophy I follow that has helped my trading massively.
The difference between a new trader and a professional trader is this: A new trader thinks about how much money they can make, while a Professional Trader thinks about how much money they can lose. Do you see the difference? The moral of this story is that trading is risky, and although it is fun to think about all of the money you could potentially make, most new traders seldom like to think about the fact that one bad day of trading can cut their account in half, or how a misunderstanding in risk reward ratio can lead to taking far greater losses than positive gains. The market doesn’t care about how much money I have, what I lose or what I win. The market itself is pure and emotionless, but is driven by the emotions and beliefs of the people who participate in it.
This allows me to have a clear advantage over most traders if I can follow these simple rules while trading:
(I will explain these concepts now)
This is very simple math and this will keep you from not only having a really bad day trading, but also helps prevent you from biting off more than you can chew. It answers a very simple question of what lot size should I be trading? Here is an Example:
If I have an account balance of $1,000, then 5% of that is $50. So, if I am trading a lot size equating to $1, then a -50 pip stop out would reduce my account by 5%. This means that the most I am ever willing to lose on any one trade is 5% of my total account. Now I am not advocating take a -50, but you get the idea. The dollar figure and lots size is proportional to your account balance.
This is the mark of a professional trader and for me, this was a huge milestone in my personal trading. In order to understand what my risk and profit target is getting in to a trade I needed to really understand how the market works. When I can comprehend what I am looking at on my screen and I can say to myself (or anyone else) “this is good entry because….. and as a result of this I will know this trade is behaving when it does X and I will know it’s time to dump it if it does X,” then I am on my way to making some money in FOREX. This is how you make money. There is no luck involved. It comes down to being able to identify a trade set up and being able to pull the trigger. In actuality, this is the easy part. Let’s talk about where things really get hard…
If I am trading from a place of indifference all the time, why would I ever need to run a stop-loss? The answer is that we are a human beings and no matter how emotionally stable we think we are there will come a day where the market spins you out and makes you feel like you know NOTHING about trading. Any long time traders know this to be true, no one is immune from taking losses. The mark of a true professional is how clever we can be, and gracefully we can lose (I’ll cover this in the next section). To protect ourselves from ourselves, we need to preset a stop-loss when going into any trade that is automatically set the moment I click in. It is there to serve as a safety net to ensure that my emotions will not get the best of me in the event that things go wrong, which they will.
As I mentioned above when explaining the importance of a stop-loss, the next logical question is “what should my stop-loss be.” For me I use a 1:2 risk reward ratio. I will explain how this works. If my target PIP goal is 50 pips, then my stop should be set to -25. This way if I am making smart trades and my win Ratio is 50%, then I am profitable in my account. I’ll give you this analogy: If you flip a coin, you have a 50/50 chance of calling it correctly. Simple right? Trading should be no different and here is why: If I am only winning 50% of the time but I make 50 pips every time I am correct and lose on half that (-25) when I am wrong, then over a long period of time I am going to remain profitable in my account. This is what I meant when I was referring to losing cleverly and gracefully. Obviously, I don’t advocate blindly trading your account but I love the simplicity of this because you can become a profitable trader with a 50% win rate! Awesome.
An experienced trader trusts their methodology. If any strategy is going to be successful, you need to give it enough time to work. In the first year for me, it was all about gaining experience and trying not to lose money in my account. Every year after that has not become about how much money I can make, but about how little I am going to lose. My experience has shown me that the more I can depend on high probability averages (like a 50% win/loss rate on my trade) and trust them to be true, the more confident I become in the methodology. When a trader combines a sound methodology with experience, and solid foundation in Money Management and risk mitigation, then you are well on your way to becoming a Professional Currency trader.
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