The answer to this question seems to be very simple … preferably effectively and in such a way as to lose as little as possible and earn as much as possible. This one sentence hides the secret of making money on the capital markets. Let’s start with the explanation, is this really the FOREX?
Forex is nothing more than a huge global market where, 24 hours a day, 5 days a week (Monday to Friday) someone almost constantly buys and someone else sells currencies. It is an international market built on the basis of a connected IT network of banks and financial institutions around the world, and its participants are both banks and financial institutions as well as individual investors.
You can read more about the FOREX market it self here.
Returning, however, to the topic of this article, as I mentioned, “it is best to trade effectively and to lose as little as possible and earn as much as possible.” To illustrate this a bit more precisely, it should be noted that investing involves risk, so no one will ever give us confidence or guarantee that we will earn 100%.
Markets are definitely a much more complex structure that reflects the sentiments and behaviors of many people around the world, and which way they go depends on many people and their decisions that we are not able to predict. So it seems almost impossible to profit from every single transaction.
The secret is in statistics and in probability. I will use here a quote from the famous trader Georg Soros:
“No matter how often you are right or wrong – it matters how much you can earn when you are right and how little you lose by being wrong.”
So what matters is statistics in the long term and proper capital management, which, with a properly calculated probability, will give us an advantage on the market.
What’s with this statistic?
As I mentioned before, it is almost impossible to close every new trade for profit. Sooner or later we will make a mistake, the market will go in the opposite direction and we will have to accept it and account for a loss.
The most important thing in trading is that your final balance is in plus. Therefore, it does not matter how many times we lose or how many times we earn, only whether our losses will be small enough and profits large enough, so that the final balance of our account is greater than at the beginning.
Two models of strategy
No matter what strategy we invest and based on what signals we open our positions. We are able to divide all possible strategies into two types, which differ in the ratio of risk to profit.
The first type of strategy are those we could call more conservative. They are characterized by a much lower profit to risk ratio (R: R – risk: reward). This means that perhaps our potential profit will be less than the loss we are willing to accept.
These strategies are usually highly effective, so that even if our one-time loss exceeds the profit from a single transaction, in the long run we should still earn.
The second model consists of more aggressive strategies, which assume that the potential profit from a single transaction should be at least a few or even several times greater than the risk taken.
These strategies are characterized by much lower effectiveness and very often the number of losing positions exceeds the number of profitable ones, while thanks to a very favorable R: R ratio they allow you to earn in the long term (often more than “conservative” strategies).
How to use the probability to earn more?
If we have our own personalized strategy and in the research process we have determined the average profit / risk ratio and what percentage of all transactions are loss positions, we are able to calculate the optimal capital commitment to achieve satisfactory profits.
If the historical rate of your profitable trades is 70% and the average R: R = 1: 1 it means that after making 100 investments with risk in each single trade = 1%, your account should increase by 40% (100% + 70% – 30% = 140%).
Therefore, if we know that our effectiveness is 70%, we can assume that even if from the pool of 100 transactions we will first hit a series of losses that will charge our deposit by -30%, we will still have 70% and a high probability of the upcoming series of profits.
Thus, we can see that even if we increase the capital commitment in each transaction to 2%, the initial losses should not exceed 60% of the deposit and the potential profit of 40% could reach the level of + 80%.
This, of course, is only a textbook assumption (which does not include compound interest) describing what this might look like in theory. In practice, however, each such change should be tested (preferably on a demo account) to check whether the maximum capital loss will not exceed our deposit and whether our psyche will allow us to lose such a large loss and we will still be able to stick to the strategy and enter into further transactions.
When analyzing your own plays, you should pay particular attention to the lossy ones and not repeat the same mistakes several times.
Let’s look back at what profits brought us profits and try to repeat them – let’s create profitable patterns, for example, we earned several times entering the engulfing formation in the resistance zone – if it worked often, it is likely that it will work again someday. To this let’s add statistics – if so far a given scheme has been successful in 50% of cases, this is the probability that it will work again.
It is also worth quoting a quote by Stanley Druckenmiller:
“The way to make high long-term returns is to keep capital and make the occasional brilliant move.”
He says the key to success is saving capital. This means that we should not risk too much in a single trade, not throw ourselves at every opportunity, and most of all cut losses – keep our capital so that we have a chance to earn when the perfect play is hit.
I know this is a slightly different position than increasing the risk threshold in a single trade. Which one you choose for yourself depends only on you, but if you are just starting your adventure with speculation, stop your impulses and the desire to earn money quickly. Big money will come with time… learning and gaining experience are the most important.