Forex Trading Strategies: Money Management
How can you be profitable in forex trading? Look at this table and study it well — it could change your trading forever! In it, you have profits and losses in pips for various combinations of TP:SL (take profit target and stop loss distance, in pips) for different win rates. The profits are given in pips for a total of 10 trades. Once you have looked at it enough, read on for very important insights on how to become profitable in forex trading. A must read!
The win rate and your trading edge
It is possible to become systematically profitable in forex trading with MANY strategies and systems. Some trade 10 times per day and stare at the screen all the time so that they get very tight entries, others place 10 trades per week, others 10 trades per month. Some use indicators, others watch for “patterns” (head and shoulders, double top/bottom, pennant, etc.), others use pure price action, others use moving averages, some trade the news, some are macro position traders, and so on. In ALL these “styles” there are systematic winners, occasional winners, and systematic losers. One thing is sure: it takes NO skill to place one profitable trade, or even one week of profitable trades. What we want is to become systematic…
Obviously, what we would prefer is to have a better-than 50% win rate. Ideally this is indeed the case, but what is likely to happen is that your win rate will vary per week. One week, you may have a 30% win rate (3 winners out of 10) and another week, you will have a 70% win rate. What you want is to 1) be profitable, on average; 2) survive losing streaks to have money to benefit from the Law of Large Numbers and the power of probabilities.
Your trading strategies must allow for generally good entries, which means they improve the probability of the trade moving into profit after entering and hitting your profit target relative to a coin toss and they limit losses relative to profits. The 80:30 system seems like a miracle: you are in profit even with a 30% win rate… the problem is that setting 30 pip stop losses and “far-away” profit targets (relative to SL) increases the probability of price hitting your SL before it hits your TP (even it indeed goes “in your desired direction” in the end!), so you may indeed get an average of 30% win rate in the long run, or even worse… unless you become very good at entries, which IS possible, of course. This means you use multiple timeframes (daily, h4 and h1, for example), you identify trades in the upper timeframes and your market analysis and you “fine tune” down to h1 and even more precise, perhaps the 30 min chart. This is fine — it is all a matter of style and preferences.
Just know that these numbers are not “magic”: no matter what you do, if the SL is “much closer” than your profit target, you are reducing your average win rate. The lessons to get from this simple table are invaluable and important.
Worst case and averages
One thing to look for is what will happen to your account when your win rate is low. Here I put 30% as the worst case, but of course it could be as low as 0 winners out of 10 on the worst days or weeks. This can happen if you have a rigid strategy that you try to apply in all market conditions. For example range trading and “picking tops and bottoms” in trending markets or vice versa. Trying to “capture” the market with one overriding strategy is not a good idea. Stay open, curious, and flexible.
Looking at the “worst” weeks (supposing worst is 30%), we see that it is worse when SL and TP distances are similar, which means low reward-to-risk. Again, this seems like magic, but it is not that simple: probabilities of hitting a given price target is a function of distance (and other things). Note that several profitable strategies by hedge funds use further-away SL than TP targets, sometimes huge differences, like 200 SL and 100 TP. They do this because their probabilistic models suggest that this approach is a winner, on average, due to low-probabilities of hitting the SL. But they have the funds to survive the drawdowns and losses — you probably don’t ;)
So. Given this reality of retail traders, we probably want 1) further-away TP than SL, keeping in mind that too much difference tilts the odds towards the SL being hit due to natural “wiggle room” during a longer open trade period, and 2) a strategy that tilts the odds of price going towards the profit target shortly after entering the trade and going all the way to it. You need some kind of bias that at least matches a coin toss (50% win rate), EVEN with SL closer than TP. There are several possible approaches to such a strategy.
I prefer simplicity and no indicators. I use weekly, daily, h4, and h1 charts. Each week, I build a market bias per currency based on a mix of chart analysis, macroeconomic analysis, and what I call “flavour of the week” story (what is the market focused on now?).
Markets move from fixation to fixation. They panic over something one day, then 1 week later, they couldn’t care less… Like I tell my forex students on my online program and associated private forex trading fb page, markets are like a teen with serious attention deficit issues and compulsive-erratic-emotional behaviour. One week or month it is Euro risk and French elections, then it is Trump woes, then jobs, then the brightening picture in the UK, then they remember that Brexit has not even “really started yet” and they freak out about that, only to forget all about it until it resurfaces due to negotiations or other events… then it’s oil… the supply glut will make oil plummet… no global growth and OPEC will make oil skyrocket… Oh and look at the Fed that is talking about the balance sheet… is the jpy now on a long run trend of depreciation because BOJ is printing to increase inflation?… and on and on and on… it’s hilarious! LOL… I call these “flavour of the week” and they drive short run sentiment, which is one layer on top of the more fundamental macro picture and macro news. In the end, all these mood swings are visible in the charts, trends, and so on. When you get all this and you can analyze charts properly by “seeing” bull or bear market control and potential for reversal or continuation, you can always understand what is going on and place good trades.
OK. We want the worst case to be tolerable, so that seems to leave us with 30:20, 50:30, 60:30, 70:40, 70:30, 80:50, 80:40 approx. If you are a day trader who wants to enter several trades per day, you will go 30:20 or lower. For traders wanting to place trades that are open for approx 3 hours to 3 days, you will go with the others. If you want to do macro position trading which requires more macro-financial analysis, you will go in the higher ranges, perhaps 150:70, 300:100, etc. Note that these are approximations… you should set SL “on the other side” of support / resistance levels and your profit targets “before” them, which are seen visually and also on round numbers, main MAs (14, 21, 50, 100) in h1, h4, and d1 charts, etc.
I personally do both swing trading and macro position trading and I find that the sweet spot for me for swing trading is approx 70:40. Now note that 70 pips of travel is a good distance that can sometimes take as little as one hour or as much as a full week, when the range is very tight and the market is undecided. The 30% win rate profitability of a 70:40 approach is -70 pips, while the average is +150 and the best weeks are +370 pips. Note that you can play with your system to adapt to the market as things happen. Always be open and flexible. For example, when I see that the market is moving strongly in favour of my trade and I think the short run macro fundamentals and “flavour of the week” support the momentum, I sometimes place the trade at break even or slightly in profit and I set a huge profit target, like 200 or 300 pips, based on chart analysis. It then becomes a low-probability bet with high potential profit and zero risk. But don’t do this all the time, because your win rate will suffer and your average profitability will drop! It’s an art!
Remember that stop loss distances of 20 pips or less are highly exposed to stop hunting. Place those trades only in highly liquid markets (weekday mornings, New York time and all day 8 to 5 for Europe). When market volume is higher, there is less risk of price manipulation and stop hunting. Like and share to show appreciation!
Pascal Bedard
www.pascalbedard.com
pbeconomiste@gmail.com
