Psychology lesson: Assessing the risks to a trade.

As part of any trading strategy, it is essential to be aware of and assess the risks to a potential trade. When trading forex, I consider two types of risk.

1: The financial risk.

2: A particular cause for a trade to stop out.

Assessing the financial risk is fairly simple. It's a case of deciding a percentage amount of the account to risk. Then setting the lot size accordingly. The general suggestion when placing Forex trades it to risk 1% on every trade. If you then implement a risk / reward ratio of 1.5:1. You can lose half your trades and still make money over the course of a year.

1% is a general recommendation (especially for new traders) but as you gain more experience, you can slightly raise your risk percentage, perhaps to 1.5%. And continue gradually raising, in small increments, up to 2% or possibly even 2.5%. Personally, I wouldn't go above 2.5%, simply because if you lose four trades in a row, which is very feasible, all of a sudden, that's 10% of the account gone. That is a big psychological blow, which could cause you to make emotional decisions.

It is important to risk the same % amount for a set number of trades, this allows the mathematics of a higher risk reward ratio to work.

Assessing the potential risks in terms of a trade stopping out is a little more complicated.

There are always many potential reasons a trade could stop out, profit taking, price reversal from strong resistance, or a fresh catalyst occurs in the opposite direction of your trade, such as a data release, political statement or world event.

Each trade I take I ask myself the question: if this trade stops out, would I still say I should have taken it?

Trading is all about making good decisions in the moment and please excuse the sports analogy, but if I was a betting man and Real Madrid were playing Accrington Stanley. I would pick Real Madrid to win, but if during the game, Madrid had four players sent off and Accrington Stanley won 1-0. If you put me back in the moment before the game, I would still say picking Real Madrid to win was a good decision.

In trading terms: if the GBP reports excellent GDP data and strengthens considerably Vs the USD. But there is only a few pips up to a strong daily resistance point. I would suggest it's a 'good decision' to wait for the resistance to be broken before having confidence the GBP strength will continue. If the price does ultimately break through the resistance, it will look like you should have traded it. But I would still say it was a 'good decision' to wait for daily resistance to be broken.

Conversely, if you think the GBP momentum can continue and there is no strong resistance ahead. You take a 'long' GBP trade, But the GBP strength reverses due an unforeseen comment from a B.O.E member and the trade stops out. I would suggest that at the time you took the trade it was a 'good decision'.

In conclusion, sometimes you'll note a risk but think the move is powerful enough to negate it. And sometimes you'll think the risk is too big to take the trade. But if you can consistently make 'good decisions' even though in hindsight it may look like it was the wrong decision, it was the right decision in that moment.

And if you couple 'good decisions' with strict financial management (1% every trade, higher risk reward ratio) over time, those decisions will work in your favour and over a 12 month period, the account will ultimately end up in profit.

Feel free to email any questions: johnelfedforexblog@gmail.com