I am constantly amazed at how few Forex traders and brokers have no concept of money management. Money management is controlling your risk through the use of protective stops, while balancing your potential for profit against your potential for loss.
An example of poor money management I see almost daily… many traders refer to a trade that might lose them $500 if they are wrong and make them $1000 if they are right as a two-to-one risk/reward ratio. Yet, that is wrong because it is just as important to knowing proper win/loss ratio of knowing how much you are going to lose if you are wrong and how much you are going to make if you are right, but what are the odds of making money… of being right? What are your odds of losing money, or being wrong?
Good money management means you know your profit objective and the odds of being right or wrong, and controlling your risk with protective stops. You are better off with a trade where you might lose $1000 if you are wrong and make $500 if you are right, that would work eight times out of ten, than to take a trade where you would make $1000 if you are right and lose only $500 if you are wrong, but works only one time out of three. Obviously, this mistake can be overcome only by developing and testing money management concepts. An entire book could be written on money management principles… but the key is knowing your win percentages along with proper risk/reward ratios.
You are better off with a trade where you might lose $1000 if you are wrong and make $500 if you are right, that would work eight times out of ten, than to take a trade where you would make $1000 if you are right and lose only $500 if you are wrong, but works only one time out of three.
Eric,
That quote is great in theory, but show me a system that makes 80% on a regular basis. I know all the arguments will come out now, but realistically, most traders require a r/r greater than 1:1.5 because many will not succeed a win % of 50% and if they can regularly get 50% and their r/r is > 1:1.5, then you have your holy grail.
I believe this concept you are discussing is called “Expectancy” … Van Tharpe (Trade Your Way to Financial Freedom) writes about this. It was definitely a good read, and something you don’t find in a lot of the trading books.
On this page you can read about Expectancy and what it means from Van Tharpe himself.
I’ve debated this with myself all the time would I rather have an 5:1 RRR or just take a 1 to 1 and win 60% of the time (which it tough). I think most traders should backtest their system and see how many times it would hit profit or loss targets and then get themselves a steady minimum Risk Reward Ratio they must follow (for me that is 1.5:1)
