Everyone knows the saying “slow and steady wins the race” from the childhood story of the tortoise and the hare. This expression could not apply more to traders. More often than not, traders enter the market quickly, without properly calculating the risk of their action. This article will show you a few steps to help you slow down and calculate an accurate risk before even entering the market. This guarantees you to have a more efficient, effective and profitable trades.
Step 1: Analyse and pick a direction
Analyze the direction of the market. Look at the charts and determine if you expect the market to go up or down.
Step 2: Look for confirmations or rejections
Check for confirmation or rejection of your analysis. Think about both sides and come up with reasons for why you made the decision you did, in addition to what could go wrong. This will help you more accurately calculate both the reward and the risk. It will also help you prevent yourself from becoming blinded and being biased towards one side. Ultimately, this will be beneficial for two reasons: 1) It confirms you actually want to make the decision you are thinking about 2) It keeps your mental state stronger as you know what to expect and even if your analysis turns out to be wrong you were prepared for it.
Step 3: Set your stop loss
Determine a stop loss that is low enough to give rejection to your analysis. This means to set a lower boundary where if the market reaches below, you won’t enter as it confirms your analysis was incorrect.
Step 4: Set your Profit Target
If your analysis is confirmed, set analysis for where you think the market is heading. Will it go down and then up? Will it only go up? This question is key to ensuring that you get the most reward for your risk. Look at example one to see the possible consequences of not considering this.
Step 5: Determine an entry point.
The reward/ risk ratio should be greater than one in order to make a reasonable profit. People often think that the entry point is just whatever price you end up starting a trade at. However, you should chose an entry point before making a purchase, not the other way around.
Step 6: Estimate your risk-reward ratio
- Risk = entry point – stop loss.
- Reward = profit target – entry point.
- Risk-reward ratio = reward / risk
If the risk-reward ratio is less than 1:1 you should readjust your entry point to make sure that you’re entering at a lower risk. This readjustment is very straightforward if you use the correct calculations for risk and reward.
Using this calculation, you will ensure that even with losses, you will still be profitable and still have positive expectancy.
Let’s look at a counter-example
This is an example of a trade made without following these steps of analyzing and determining an efficient entry point. This is what you should not do.
In the example, the entry point is not well placed. The stop loss and profit target have been placed according to actions of the market, but this trader didn’t consider the effect the chosen entry point would have on their risk-reward ratio. The risk is about 8, while the reward is about 6, giving a risk-reward ratio of 0.75:1. Even though we know this trade will be successful, in the moment, all the trader knows is that the risk-reward ratio is 0.75:1. Any risk-reward ratio under 1:1 is an unwise trade.
Let’s look at a good example
This is an example of a trade made following these steps of analyzing and determining an efficient entry point:
In this example, the entry point has been well-placed. The risk is about 5, and the reward is about 9, giving a risk-reward ratio of 1.8:1. This is a much better entry point than in the previous example. It is placed low enough to create a good risk-reward ratio for the trade, but not so low that it is too near the stop loss.
In the examples above we’re looking back, so we know that these trades will turn out profitable. However, when the trades were being planned, the trader didn’t know that. More often than not, traders enter the market quickly, without properly calculating the risk-reward ratios of their trades.
Focusing on cutting down losses rather than attempting to raise rewards will ultimately result in better outcomes. Following these steps is crucial to making educated trade risks and cutting down these losses. Even if you’re right about the direction of the market, if you don’t get through this process and determine the best entry point possible, you could still enter the market at the wrong time. In trading, timing is everything. In the long term, it’s more profitable to have several small losses among your wins than one enormous loss, wiping your account out.