A Common Trading Scenario:
A beginning trader has won five trades in a row. They think let’s risk all my account on one trade. They lose that one trade and it wipes out all five wins plus their original investment capital. This trader blames the market for being rigged and stops trading. This type of trader could stop trading and hire their local adviser at Edward Jones, or they could read this article and work on their risk management.
What the solution?
This is what every begginer trader goes through when they first start trading. Ask any trader if they have blown an account and my guess is 99% of them have at some point. We all have blown an account when we where first learning how to trade, and I understand that it could happen again if we don’t follow trading rules. That is why we have titled this page The 2 Most Important Trading Concepts.
I have followed some type of risk to reward ratio ever since. we have outlined ideal risk to reward conditions at the bottom of this page but remember that markets aren’t 100% predictable. From my trading experience, we also understand that is it possible to have a lower accuracy rate of 70% while still trading profitable or keeping an account at break even.
Who Uses Risk to Reward and Accuracy Rate?
Every professional trader tracks their risk to reward ratio and accuracy rate. I learned this concept from Larry William’s book called Long-Term Secrets To Short-Term Trading. This is a book written by a professional commodities trader who is also considered a trading guru. This is the first book that I have read that stressed money management for trading. Williams also talks about mapping out your trades before you enter the position. This mean that you should know the maximum profit goal you are trying to achieve and the maximum loss you are willing to take.
The accuracy rate of a trader is simply a calculation of how many trades are won vs how many trades are lost. A professional trader will win 80 to 100 percent of the trades they get into. This is no different than a professional basketball player who wants to make 80 to 100 percent of their free throws. The more points they score, the more wins they get for their team.
I have learned that the key to becoming a successful trader is to win as many trades as you can. They key is to get consistent. You won’t start out a pro your first trade you make so I always recommend using a demo account until you consistently win trades. With a demo account, you have nothing to lose and everything to learn.
Risk To Reward
A trader’s risk to reward ratio is how much capital a trader is willing to risk per trade. When I first started, I learned this from a trader that phrased this as how much are you willing to lose per trade? What he was explaining is that you should always have equal or greater Reward to Risk when you are trading. Let’s imagine you are weathy and have a $100,000 Forex trading account. How would your trading strategy change with different trading styles?
All of these trades would last hours or less than a day. As a rule of thumb you only risk 3% at a time. In a $100,000 account this would be $3,000 maximum at risk at once. As a day trader or scalper your risk to reward ratio should be 1:1, so that means you are willing to lose $1,000 to gain $1,000. With an accuracy rate of 90% you would be making $9,000 and losing one trade at $1,000 that would mean your net profit would be $8,000.
Swing traders use either the daily or 4 hour chart and will stay in a trade for more than one day. This type of trading would use a smaller position size and needs to have a larger risk to reward ratio. This trader is willing to risk $500 for a $1500 profit. If this trader had a 90% accuracy rate, then their profit on 10 trades would be 13,000 gain with a loss of $1000 meaning this trader would have a net gain of $12,000.