Balancing Risk and Reward
Written by Andy


To start with, you are going to be doing this as a practice. However, as this is going to be a source of income to you, you must note and do everything as though you were contacting your broker in the next five minutes. Quite honestly, the biggest hurdle to making a success of trading is the mental one, and you will find virtually every trader will agree with this. That’s why you will work your choices until you have confidence in your powers of selection, and you will go through with your decisions.

When you do start to trade with real money, you are going to find that your emotions kick in much more than you thought they would. It’s natural. What you don’t want is that stopping you trading the way you have learned, and making a success of it.


They say that even the best traders are only right about 70% of the time. The profit is in cutting your losses and riding your gains. That’s why whenever you enter a trade you should know the upside and the downside, and aim to get a potential 3 to 1 or better ratio – exceptionally 2 to 1 for day trading.

The upside you can estimate from Fibonacci lines, taking at least the 38.2% as a likely retracement, if that is the type of trade you enter. The downside is some-thing you also work out before entering a trade, as you need to have a stop loss position decided. From this you can see how large a trade you can afford to make, as you want to be comfortable with the amount that you lose, which shouldn’t be more than about 2% of your total trading capital.

For instance, if you want to set your stop to, say, twice the normal standard deviation, to keep it close but allow that you won’t get stopped out randomly, you can see how much you can lose if the trade goes wrong. Working it back, you can then see the most that you can risk in the trade so that you only lose 2% of your capital. No-one can get every trade right, and if you allow that sometimes you can lose several in a row, you don’t want to be losing 10% or so at a time, otherwise it would take you a long time to recover your losses with the remaining funds of a half or less.

With practice, you’ll find that it’s almost automatic to pick good risk/reward ratios, as your eye will lead you to them. Until then, you have to be sure to figure it out, and write it down. A trading diary will give you valuable information about how you viewed the past, and what mistaken thinking you might have had, that you can learn from. In fact, a trading diary can be the most important thing that you do. When you write your thoughts and actions down, you will have to answer to yourself about why you did things, and it gives you a chance to see if you are being emotionally influenced, or if you are trading your system. There is a saying amongst traders that goes “plan your trade and trade your plan” – in other words, not only plan before you start, but also continue your trading in the way you decided, without changing your ideas in midstream.

Knowing when to Stop

Stop losses are an important tool that helps investors to rapidly close their position if things start to go drastically wrong. They ensure that even if their human eye misses a market swing, the order is still executed. When opening a position, a trader can specify at what point they want their trade to be closed. This needs to be set wide enough to miss normal market fluctuations but close enough to ensure a true rebound in market trend is picked up early and losses are minimal.

It therefore takes some skill to estimate where to set a stop loss and the actual point will vary on the market being traded as well as the risk attitude of the investor. Once the stop loss has been placed, as soon as the market touches the specified point, even if only briefly, the position will be automatically closed out. This means if an investor steps away from their trading platform whilst they have a position open, they need not fear missing a dangerous market movement, as they know the risks are covered.

If the underlying market is moving very fast and the broker receives a lot of orders simultaneously there may be a small delay before the order is executed; this is known as slippage. To prevent this a trader can opt for a guaranteed stop loss but some brokers charge an additional fee for this.

It is also possible to lock in profits in a similar way using stop wins. This allows a position to be closed automatically once a pre-determined level of gains has been earned. This may not sound like a risk management strategy but in reality once a trade reaches the top end of its movement it can very quickly retrace, resulting in losses. It’s therefore important to exit the market at the right time.

Covering your Costs

Some investors use the market to hedge against existing costs to protect their profits elsewhere. For example, a cruise liner relies on oil and this can be a major cost for a company with a fleet of ships. They may opt to invest in a market that brings a profit if the price of oil rises, helping to offset the additional costs of purchasing it. If, of course, the price of oil moves in the opposite direction, the company profits by being able to buy cheaper oil but the investment suffers.

There’s no getting away from the risks that are inherently involved in trading, but by using every tool possible, investors can minimise their potential losses without compromising their possible gains.

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