Managing your positions correctly is crucial if you want your trading business to stay in business. Traders do a variety of different things to manage their positions, but what is most important to me is to re-evaluate the risk/reward ratio with every tick; also known as the traders equation. Before we enter a trade we should properly evaluate our risk, reward, and probability that the trade will work. If we have not evaluated all three of these factors then we did not do our homework right and we will most likely be stressed while managing our position. We most constantly update our risk/reward as the market is updating with new price action information. If you are a true price action trader you want to evaluate every tick and make sure the math is still working out to your favor. Let’s take the EURUSD 4hr chart below.
The EURUSD has a lot of news surrounding it this week which could make it a very volatile currency pair. We gapped down about 150 pips but have since then been reversing up a bit. From looking at the chart we can see a swing low in the 1.08 area. This is a clear target for many bears that are trying to push the market lower. We have a couple of areas where the bears might find logical prices to put a stop loss. The first is the lower ledge, with a top of 1.1235. If the price goes above this it will be less probable that we get to the 1.08 area, or at least get there anytime soon after that. We also have a second higher ledge for those traders that want just a little bit more room, and that ledge sits in the 1.1435 area. The price now rests in the 1.1115 area. Let’s pretend like we enter the trade now and believe we have a 50% chance that the chart will make its way down to 1.08 before it reaches the higher second ledge at 1.1435. In this case our target is about 315 pips away. Our stop loss is about 320 pips away. As we can see, the market is fairly balanced and often presents us trades like this that are not too heavily favorable to one side. This is because we have a balanced or efficient market. While you are taking a trade that you believe is sure to win, there is always someone just as smart or smarter who thinks the exact opposite of you and may be right. In our case we have a 1:1 risk reward ratio, and what we believe to be a 50% chance of being right. If you are taking setups that have a 50% chance of being right, and you only stand to reward yourself with as much as you were risking, you will soon blow up your account or at the very least never make a dollar. If you win 50% of the time your rewards needs to be twice as big as what you risk in order to profit consistently. Therefore, right from the start we know that this trade has unfavorable math.
Now how about that first ledge in the 1.1235 area; what if we risked to there? In that case our stop loss (risk) would be about 115 pips. Our reward stays the same at about 315 pips away. Maybe we believe this risk level 115 pips up is a bit tight, and now our probability that we will hit our target is only 40%. That does not matter because we still have a positive trader’s equation. If we only win 40% of the time but our rewards are consistently twice as big as our risks we can still stay in business. Take 10 trades.. you win $200 on four of them, but lose $100 on the other six. $800 in wins minus $600 in losses gives you a net of $200. I am ignoring commissions in this example but just wanted to illustrate how a 40% winning percentage can be a profitable strategy.
Now let’s take it a bit further and say we took the latter trade that had a 40% chance. Let’s pretend that we entered at the 1.1115 area as anticipated and the chart dropped 150 pips. We are not about halfway to our target. We can no longer risk to our original level. If we kept our stop loss there it would mean we are risking the 150 pips we just gained, as well as the 115 pips of our original risk level. This means we are risking 265 pips. Not only that, but our reward has also shrunk. We originally had a reward of 315 pips, but at this very moment we have captured 150 of those pips already. This means we only have about 165 pips left to our profit target. If we leave everything the same it means we are now risking 265 pips to capture another 165 pips. There are very few chart setups that provide a probability percentage high enough to take this trade. Most setups you see on the chart have about a 40-60% chance of success. This is because of the point I brought up earlier that we have a balanced or efficient market. This means that one side will never have a huge edge… and if they do that edge will disappear quickly. Calculating probability can be very subjective but when in doubt always use a smaller probability such as 40%. This will force you to go for a reward twice as large as your risk and provide favorable math for you almost every time. With experience you will start to notice chart setups that you are fond of and you will get a sense of which trades you like to take.
Back to our example, risking 265 pips to make 165 pips will most likely be a losing strategy over time. This means we need to recalculate probability and our risk/reward. At this point our target is 165 pips away. Risking half of that, around 80 pips, thinking the probability is about a 40% chance that we get there makes your math favorable and keeps your traders equation positive. This type of recalculation needs to be done with every tick of the market. If not, I believe your trading business runs the risk of bankruptcy.
When I talk about the trader’s equation this is what I mean for all the math wiz’s. The probability that your target is reached multiplied by the potential reward you stand to gain must be greater than the probability that your stop loss is hit multiplied by the potential risk you stand to lose. This is what we must calculate at all times. We should obviously do this calculation when we first enter a trade, but more importantly when the trade starts going in our direction we must continually be calculating this equation. Once we have unrealized profits, they are still profits! That is money that is in our account now! Treating it as monopoly money is not the right thing to do. We must protect this capital and pretend as if we are putting on the trade at that very moment. This mean adjusting our risk/reward calculation as the trade goes in our direction. If you don’t it will probably cost you. Literally!
TraderStos on Instagram
**Please note that trading is risky and I am not qualified to give investment advice. You should invest your money at your own risk and only after you have done your due diligence. Do not take anything here as a recommendation to buy or sell any securities. I am willing to talk trading strategies and connect with other traders via email or instagram.
A quick video demonstrating how to use The Fibonacci retracement tool