When entering a trade, how high probability setups forex exchange you choose the point of the stop loss and take profit? Clearly, this decision will have an impact on how profitable your trades are.
However, did you know that the placement of youdr exit levels can actually have more of a bearing on your profitability than the decision on which direction to trade? In the volatile forex market, it is actually true. Given how important this decision is, it is surprising how little thought many traders give to this component of their trade. In this article, I want to explain a quantitative strategy that will help you select stops and take profit levels for maximum profit. I also want to debunk some of the common misunderstanding around risk-reward setups, and show how following poor advice can ruin a potentially good trading system. Why Guessing Stop Losses and Take Profits is a Plan for Failure A trading position will normally exit at one of two points.
When deciding trade exits, it is sometimes tempting to make an educated guess. Some traders use technical features such as chart candles, trends, resistances and supports. Others simply choose a fixed ratio of profit target to stop loss. When you guess the exit levels for a trade it is very easy to either overestimate or underestimate price movements. It is not repeatable and that makes it very difficult to analyze or improve performance. SL combination or because your strategy is not working. It is very difficult to automate methods that rely on gut instinct or other subjective decisions.
There is nothing wrong with using technical analysis as a guide for timing the trade entry, nor for judging how far the price might move. Rather, the method I describe below is used alongside both charting and fundamental analysis. TP as Proxy Risk-Reward Forex trading forums are full of well meaning, yet rather misguided advice about risk-reward setups and how to set your stop losses. Unfortunately, many of these people fail to understand the true meaning of risk or reward. The idea that simply setting your stop loss smaller than your take profits will achieve a certain risk reward is complete nonsense. By that definition, this would seem a fantastic game to play. However, suppose we know that two million people enter the lottery.
1 you put into this lottery, you’d expect to get 50 cents back. Most would now agree this is not a very good game. Even though on the naïve trader’s reckoning, it had a reward to risk ratio of one million. The Risk-Reward Relationship The first thing to realize about setting trade exit points is that the amount of profit you want to make on a trade is directly proportional to the risk you will need to take to capture that profit. This is not a supposition, but rather a mathematical fact. The trend has been in place for around one day, so the trader thinks there is a good opportunity for profit. Now let’s analyze this trade setup in more detail.
The first thing to notice is the trader wants to capture a profit of 70 pips on the trade. So what is wrong with this setup? JPY has an hourly volatility of 26. That means, on average, the movement of the price over one hour is 26.
Sometimes more, sometimes less but this is the average. This means the trader is trying to profit by 70 pips. In reality, he is actually betting against the market because he is relying on the fact that the price will not descend more than 20 pips from the open price during the life of the trade. Choosing the right stop loss placement is a critical decision but it’s often left to chance. This Metatrader tool advises where to place stops and take profits on any order.
Just set the desired trade time and win ratio and the indicator does the rest. JPY is currently over 26 pips, this much stability in price would be highly unlikely. JPY moves up or down by 26. 4 pips every hour, why would it do anything different for this particular trade? The answer is that it would not and the trade would probably strike the stop loss for that reason.
Due to the volatility in FX, this is true even if the predicted trend continues. The basic problem with the setup was that trader was trying to capture too much profit without accounting for volatility. Remember that in forex, volatility is not something you can avoid by careful trade picking or a clever strategy. That’s why it is far better to make volatility work for you rather than against you.