Forex Money Management: Risk Reward & Position Sizing

Novice traders often run into trouble by becoming overly confident in a particular trading setup, believing it to be a surefire winner. They may then over-leverage their trades, putting themselves at risk of a significant account loss. While the setup may work out in some cases, one wrong move can lead to an emotional spiral and further trading mistakes. This kind of thinking reflects a lack of understanding of risk-to-reward scenarios and position sizing, which are crucial components of successful trading. This article aims to provide a better understanding of these concepts.

Thinking in Probabilities

Prospective forex traders often spend countless hours searching for the perfect trading system that they believe will make them rich by following specific trading rules in a robotic manner. However, they fail to understand that the real secret to successful forex trading lies in thoroughly comprehending and implementing risk-reward scenarios and position sizing. Forex trading is essentially a game of probabilities, and to become a consistently successful forex trader, one must view each trade setup as a probability. By thinking in probabilities, traders adopt an objective and mathematical mindset rather than an emotional and illogical one, leading them to make better trading decisions.

The difference between winning and losing traders is how they perceive the market. Winning traders view each trade setup as another execution of their trading edge and focus on minimizing their risk while maximizing their reward. Through the use of risk-reward scenarios and position sizing, professional traders can effectively manage their risk on each trade and, as a result, manage their emotions. When traders perceive each trade setup as just another execution of their trading edge and properly implement position sizing and risk-reward scenarios, they also manage their emotions because they know their potential risk and reward before entering a trade. This allows them to set and forget the trade, eliminating any potential for emotional involvement.

Cut your losers and let your…

The adage “Cut your losers short and let your profits run” is a common one in the forex trading world, but few explain how to implement it in modern forex markets. Traders often make the mistake of setting tight stop losses and overly ambitious profit targets for each trade, ignoring the fact that the forex market is unpredictable and can experience significant ebbs and flows. This volatility can spell disaster for traders who lack a solid grasp of risk-to-reward scenarios and position sizing.

Risk to Reward Scenarios

Let’s dive right into the main point: every time you spot a potential trade setup, you should consider the risk to reward scenario. For example, if you use price action strategies and identify a promising pin bar formation on the daily chart, your first step is to determine the potential risk on the trade. As a forex trader, your top priority should be risk management, rather than focusing solely on potential rewards. Once you adopt this mindset and learn to manage risk effectively, you’ll naturally become a professional trader.

Position Size

Proper position sizing is crucial in maintaining a favorable risk to reward ratio for traders. Many traders make the mistake of adjusting their position size based on their desired stop loss rather than the other way around. For instance, if a favorable trade setup requires a stop loss placement of 200 pips, risking $100 per trade, then the trader should reduce their position size to meet the stop loss size instead of adjusting the stop loss to fit their desired position size. This means reducing the position size from $1 per pip to $0.50 per pip, which equates to a total trade risk of $100.