MONEY MANAGEMENT
What’s Your Trading Price?
The most important element of a trading system is managing risk. Here’s how you can understand the risks of the forex market and other financial markets.
Novice traders tend to think of trading as a unique opportunity to make a large amount of money. They slip on their rose-colored glasses and envision profits that will enable them to quit their current jobs, let them travel all over the world, and work only when they feel like it. Immersed in these rainbow thoughts, they open trading accounts, begin trading, and suddenly find themselves faced with the cruel reality. Money drains out of their accounts, followed by enormous losses that force them to close their positions. They quickly realize that the market isn’t about making money. Instead, it’s all about losing it.
Understand your risks
Why do so many traders leave the business after suffering massive losses? There are many reasons, and one of the major ones is that there is too much focus on potential profits. A beginning trader tries not to think about the risks, which is wrong. Understanding and taming risks may be the major component of trading forex and other financial markets.
Remember, mathematicians developed the formula for mathematical expectation of profit long ago. There’s no reason to be intimidated by it, even if you are not strong in mathematics. This formula is one that we can all understand. Here’s what it is based on:
The probability of the profit you could obtain, multiplied by the amount of the profit
minus
The probability of the loss you could obtain, multiplied by the amount of the loss itself
The result will be your trading price.
This concept can be written as the following formula:
Trading price = T/P probability x
T/P – S/L probability x S/L
where:
T/P = Take profit
S/L = Stop-loss
Figure 1: weekly chart of eur/usd. Here you see that the weekly histogram is moving downward.