Identifying Risks and Profits and Understanding the Leverage Effect
The activity of active traders is to interact frequently with the market, which puts capital on the path to financial gains. To continuously accomplish this task and avoid abnormal withdrawal of accounts, the risks must correctly align with the ratio of profits.
The risk\ reward ratio is a tool used to determine the potential return and exposure to risks facing a specific trade. It may be defined in terms of currency, points or marks. Setting profit targets and stopping losses are essential elements in developing the risk\ reward ratio.
For example, the following long trade in the EUR \ USD currency pair illustrates the relationship between the stop loss \ profit target and the risk\ reward ratio:
Trader “A” decides to enter the EUR / USD pair from 1.1800.
- The stop loss order is placed below the 50-day simple moving average, at 1.1775.
- By taking advantage of the Fibonacci extensions, Trader “A” expects a strong bullish movement towards resistance and places the profit target at 1.1850.
The risk \ reward ratio for this trade is 25:50 or 1: 2.
In the above stated example, the leverage usage remains constant. While it is true that the maximum loss on a position is 25 pips, the optimum pip value must be found. This can be easily achieved by calculating a percentage of the account balance that is appropriate for trading risk.
Concrete guidelines for leverage implementation must be included in the trading plan. In the event of abnormally large trading operations, undue risks are assumed, and the loss may be devastating. The degree of leverage placed on a single position can be determined in terms of available capital. Adhering to a fixed percentage, such as 3% of a trading account’s balance, is a good way to ensure adequate risk controls are in place.
It is important to remember that increasing the position size or the degree of leverage greatly increases the risk of trade. In simpler terms, the more the leverage is, the greater the risk becomes.
By far, random risk management practices are the first reason why new traders exit prematurely. By adhering to a comprehensive trading plan, using stop loss \ profit targets, understanding the leverage and concept of risk \ reward ratio, you can effectively reduce the amount of exposure to risk.