Forex Money Management What is RRR and stop loss

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Forex Money Management: What is RRR and how to set a stop loss

Many traders wait for an ideal moment to open a trade, which is no doubt an important factor. To manage the actual position and to recognize an ideal moment to close it are even more important. How to manage the position? Where to set a stop loss and what does the abbreviation RRR stand for? Read on!

Money management

I find money management to be each trader’s proprietary know-how. A higher level of know-how includes the capability of additional buying or selling of positions. However, we’d better start from the basics, each trader must learn.

As you already know, Forex trading requires discipline. First, you must decide for yourself how big the position you wish to open should be and how to identify it. I recommend that you calculate this against the size of your trading account. Conservative rules suggest that you shouldn’t risk more than 1 to 2 per cent per trade. Our video on money management advised 5%, since binary options trading is in essence much easier. Overall, I recommend that you set the risk at maximum 4% per day (not per trade)

My recommendation for a beginner whose trading account contains 10 000 usd would be no more than 500 usd per trade. The daily limit should be around i.e. 1 000 usd. This means that if you consume the limit, you should not open any more trades. In a situation like this, it’s better to quit, to analyze why this or that has happened (…was it your mistake or a false signal from the market) and carry on trading on the next business day.

Why use money management

Every long-term trader uses some method of money management. The reason is simple: To protect himself or herself against loss. Even a successful and consistently profitable trader experiences a series of losses and must be stopped by a stop loss. In a situation like this, I suggest you quit for the rest of the day and start on the next day with a fresh mind. This is a far better alternative to purging your trading account within a single day.

By the way, having no barrier in place such as stop loss is a frequent mistake made by many beginners unaware of money management, stop loss or RRR who are able to devastate their trading account within a single trade.

What is RRR

The abbreviation RRR stands for Risk-Reward-Ratio. If you set both your position’s stoploss and takeprofit (at the point of opening a trade) with a profit or loss worth 20 pips, your RRR is 1:1. This means that you may either earn or lose one dollar. If your potential profit is twice further than loss, than your take profit your RRR is 1:2.

Remember that Forex allows you a lower success rate than 50% (as you can see above, 1:2). This ratio allows you suffering 19 losses of the total of 30 trades, However, the rest i.e. 11 trades will generate profit. Figure out this using a stop loss of 100 and a take profit of 200: With 19 losses, your overall loss will be 1,900. With 11 gains your total gain will amount to 2,200. In total, you would earn 300.

If you let your losses run without instantly stopping them you may end up like the guy above

RRR and where to place a stop loss

A universal rule says that RRR should not be lower than 1:1, i.e. your stop loss should not be placed below your take profit. Well, I agree – but on the other hand this rule is too general. If the ratio of your proven profit-making Forex strategy is somewhat worse than 1:1 don’t worry and continue trading like before. This rule should not be interpreted so rigidly. A small deviation from the rule will not stop the world going round. The one-to-one ratio is a recommendation allowing for exceptions rather than a rule.

Placing a stop loss depends on your RRR. This is what must be tested on historical data. Another factor not to ignore is psychology. There are traders whose otherwise profitable strategy is set at a75% loss, a figure others may hardly tolerate.

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Final recommendation

If you are keen to learn more about forex/cfd trading and seek for new information read one of our past articles: Seven reasons why traders keep losing money.

Best of luck, dear traders!

Author

More about the author J. Pro

Unlike Stephen (the other author) I have been thinking mainly about online business lately. I wasn’t very successfull with dropshipping on Amazon and other ways of making money online, and I’d only earn a few hundreds of dollars in years. But then binary options caught my attention with it’s simplicity. Now I’m glad it did because it really is worth it. More posts by this author

Forex Money Management: Embracing losses leads to success

What is your idea of a successful trader? Is it the one whose number of profits is bigger than the number of losses? Most people believe that to be seen as a “successful trader” you must turn into profit seven, eight or even nine out of ten trades. Is it the case, indeed? What if the opposite is true? Let’s take a look at what is known as the risk reward ratio, indicating the proportion of profits and losses.

What is the risk reward ratio?

If you open a trade with a stop loss of 20 pips and take profit set also at 20 pips your risk-reward ratio will be 1 to 1. By the way, we have already discussed RRR in our article How to set RRR, SL and TP. If you read the article or know RRR from other resources we recommend you stick to the 1 to 1 ratio. However, is 1 to 1 really a barrier that should not be exceeded?

John Murphy and Michael R. Rosenberg have written a few books about technical analyzing and published results of well-known trading strategies using moving averages, RSI, MACD and others What was their conclusion? The majority of correctly set strategies (set based on the instrument’s volatility) using the ratio of 1 to 1 lead to success in at least 50 percent of all trades.

If we change RRR in our favor toward taking profit i.e. risk of 10 and profit (reward) of 20 pips our success will diminish and we will generate profit in 2 or 3 instead of 5 or 6 out of 10 trades. We must anticipate this and don’t think that by increasing RRR and extending take profit we will automatically generate profit in 50% of trades. Remember: To correctly set the time of closing a trade is equally important as the time of opening it.

RRR of 1 to 1 is, to a large extent, a psychological barrier. It’s because the bigger the take profit vs. stop loss ratio, the less successful the trading strategy.

How to profit from a loss

Paradoxically, a loss might be the driver to a future profit. If your trading strategy is successful at 50% and your RRR is 1 to 1 you need to turn at least half of your trades into profit to reach the break-even point. With RRR of 1 to 2 it is all different. 11 profits (i.e. 19 losses) out of the total of 30 trades are enough to get into black numbers.

You may argue that all we change is stop loss and take profit, affecting RRR (total success rate), but the trading strategy remains the same. You are right, we leave the strategy untouched but significantly influence its results. Try it out, at least on a demo account and some historical data. You will see that a bigger percentage of losses may eventually drive you to profit.

Forex trading, as well as trading other instruments, is, to a large extent, affected by psychology. Most traders simply don’t feel good when losing 19 out of 30 trades. Sometimes even unpleasant experiences are a path to success. Nevertheless, will the success rate change with the change of RRR? How to prevent it?

Further articles focused on money management

Author

More about the author J. Pro

Unlike Stephen (the other author) I have been thinking mainly about online business lately. I wasn’t very successfull with dropshipping on Amazon and other ways of making money online, and I’d only earn a few hundreds of dollars in years. But then binary options caught my attention with it’s simplicity. Now I’m glad it did because it really is worth it. More posts by this author

Forex Money Management

The vast majority of traders obsess over the percent accuracy of their expert advisors. Intuition makes it seem like that the more often a trader wins, the greater the chances or turning a profit. Alas, such an approach ignores a critical variable.

The average win-loss ratio plays an equally vital role in determining the net outcome. I meet a lot of would be scalpers. High frequency trading is incredibly popular, but a lot of traders involved with it only do so because it puts easy points on the board. They don’t pursue a strategy because it has any positive expectation. In other words, they are gambling and not trading.

One of the reasons that I love trading so much, and why I generally dislike gambling, is that you are always in control of the potential payout and the payout ratio. When I play blackjack, I only control the risk and payout. I do not control the ratio of the payout at all. It’s always 1:1.

My decisions in blackjack can only realistically improve the odds to 50%. More than likely, my game play will lower the odds below that threshold. Making decisions repeatedly will overwhelmingly result in human error. It’s our nature.

When I open my forex account, each trade commences a new round in the game. The critical difference between trading and blackjack is that I control the ratio of the payout, plus I still control the risk and quantity of the payout. The net outcome can still move against me due to random chance. The key distinction is that the typical outcome should shift in my favor with an algorithmic trading system.

One of my favorite trading books is Van Tharp’s Trade Your Way To Financial Freedom. We’ll be talking about this one soon; it’s the next item on Jon Rackley’s reading list. One of my favorite aspects of the book is its emphasis on money management strategies and trade expectation.

The term money management connotes many things to many people. The more accurate phrase would be to describe it as a position sizing strategy. When entering a trade, you realistically need to know:

  • What is expected loss as a percentage of the account?
  • What is the expected gain as a percentage of the account?
  • What is the percent accuracy of my trades?

Answering these questions accurately leads to the decision of how many lots, contracts or shares to trade. Controlling the size leads to controlling the outcomes. When you control the outcomes, you ideally earn a profit for your efforts.

Fixed fractional money management

Notice that I said percentage of the account in the bulleted items and not the dollar value of the trade. Thinking in terms of dollars is easier on the mind. The problems is that it ignores the wonderful benefits of exponential growth.

Every financial advisor on earth warns you that compound interest, which is a form of exponential growth, is the strongest force working for you with investments or against you with debts. Applying the same concept to trading, you want to put the power of compound growth on your side.

The fixed fractional formula is an ugly way to telling you to use exponential growth in your trading strategy. Say, for example, that you elect to risk 1% of the trading account based on the distance to the stop loss. If you have a $10,000 trading account, that’s only $100 of risk. Say that the trade works out and that you made $100. The next trade should risk $101.

Try not to roll your eyes at that one. Risking an extra dollar seems trivial and nit picky. I assure you that it is not.

I’m really not sure how to explain how all those little differences add up, but they do. I wrote a money management calculator a few years back that calculated how fixed fractional money management affects returns. The little things really do add up. With a very slight probability of winning and 50:50 odds, the returns were overwhelmingly larger when using a fixed fractional approach instead of a fixed lot approach. You should increase the position size after winners and decrease the position size after losers.

Percent accuracy is half important

If I paid you $1 for every win and you win 99% of the time, should you play my game?

You don’t have enough information to make a decision yet. You need to find out what happens when you lose.

If you lose $100 or more on the trade that only loses 1 time in 100, you should never play my game. You will lose if you play too often. And no, there is no such thing as just playing ten times and stopping. You have the same risk of losing on the first trade as you do on the 100th. It’s not safe to play at all.

The only way that you should decide to play the game is if the total payout is better than even. The total result of wins equals 99 trades * $1/trade = $99. The one loss must be less than $99 to give me the green light on playing.

If I lose $80 one time and make $99 on the remaining trials, then I will have an average win loss ratio of $99/$80 = 1.24. A system like this would be wildly in my favor.

A 60% winning accuracy is a lot more likely to happen in the trading world. Let’s say that I make $100 on every winning trade. My total winning value is 60 trades (out of 100) * $100/trade = $6,000. The maximum average loss that this system could tolerate is:

The maximum average loss that we can tolerate is $6,000 / 40 trades = $150. I should consider trading this system if the average loss comes in at $149 or less. The smaller the average loss, the greater the net outcome.

Kelly formula for Forex Trading

One problem we face with money management strategies is choosing the percentage of the account to risk. The difference between risking 1% or risking 2% of the account equity is simply one of proportion. One of the options either provides a risk-reward profile suitable to the trader or it doesn’t. The larger the appetite for risk and reward, the bigger the number involved.

The Kelly formula removes the proportionality for the question and takes a different approach: how do I make the absolute largest sum of money over time using my trading statistics. The goal is to make the maximum amount of money without getting margin called.

The formula to use is K = W – (1-W)/R where:

K = percentage of capital to be put into a single trade.
W = Historical winning percentage of a trading system.
R = Historical Average Win/Loss ratio.

The approach is most suitable for those trading small accounts, perhaps those with only a few thousand dollars, that they want to grow with maximum aggression. Losing a few dollars is thoroughly unpleasant (been there, done that!), but it’s not financially devastating, either.

It’s important to keep in mind that the Kelly formula attempts to push the trading system to its absolute maximum without busting. Knowing how close it is to the edge of busting, it’s critically important that you understate the good assumptions and overstate the bad ones. Drop the expected percent accuracy by several percentage points to accommodate the chance of error. Lower the win:loss ratio for the same reason.

The easiest way to reduce error and the chance of acting too aggressively is to make sure that you calculated the EA’s percent accuracy and its win loss ratio on a large enough sample size. I would consider 100 trades as the absolute bare minimum. 300-400 is sufficient. 1,000+ trades makes for an adequate sample for most expert advisors and trading robots.

Of course, you can always take the easier approach and simply cut the Kelly formula’s risk suggestion in half. It adds a bit of scientific flair to the strategy, while minding the fact that we are human. Watching an account drop near zero will break the heart of even the most battle tested trader. It’s impossible to stop caring about drawdown, which the Kelly formula totally ignores.

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