How Do You Approach The Market?

The first step in trading the Forex market is to determine how you are going to approach the market itself, i.e. defining your style of trading. Personally, I consider myself as an adaptive trader, which means I adapt my trading style (defined primarily by time in the trade and size of profit objective) to suit the structural implications of chart analysis.

For instance, if I spot an upcoming corrective sequence that is expected to move 100 pips, then I will approach the opportunity as a day trader seeking a more immediate exit for fewer pips. Alternatively, if a Weekly-degree turn appears to be setting up for an expected rally of 1,000 pips, then I will approach the setup as a position trader planning to carry the trade longer with a more aggressive limit exit.

No matter what the trading scenarios might be, it is the implications of a structural analysis of price action that determines the decision as to what type of trading style to apply. The reason why I prefer an adaptive trading style is because it is much more flexible than a single-minded approach focusing only on one style of trading. It is certainly not profit-maximizing to scalp for 20 pips in a fast-moving market offering 500 pips potential; and conversely, there's no point asserting on a very large trade when the market is not breaking out on a higher degree of trend.

Regardless of these considerations, I always require a Reward/Risk ratio of at least 3:1 to
consider entering a trade. This is equivalent to a minimum profit target of approximately 100 pips with an average 30-pip stop loss, including the dealing spread. If the trade setup does not appear to be offering this potential, then I do not take the trade.

The table below summarizes the different types of trading style I use by parameters of duration, profit and risk:

Based on my trading experiences, the single most important factor that determines long-term success in Forex trading is not the individual trading methods being chosen or the level of detail of technical analysis being conducted. Instead, it is the ability to consistently apply a risk management model that completely integrates the elements of risk, reward, profit target and position sizing into a smooth decision-making system.

Put it simply, a successful trader does not spend a lot of time researching about whether Gartley patterns is better than trendline analysis, or whether Stochastics is better than MACD, but rather: what is the combination of risk and reward that will best serve his/her trading objectives over time? As long as your trading system allows for the achievement of these objectives, then it is probably the right one for you, or at least as 'right' as it needs to be.

The above principle is illustrated in the following table which shows a series of 10 trades with various Win/Loss situations, targeting a minimum Reward/Risk ratio of 3:1. By using such a systematic approach, it is possible to trade profitably even with a Win/Loss ratio of well under 50%. In fact, in this scenario, breakeven does not occur until below 30%!

Professional traders know this to be virtually an obvious truth: it's not important to make the right call every time (or even most of the time), but it is important to manage risk as a variable within a system.

The reason why a trading system like this is so critical is that it allows the trader to maintain a sense of confidence and assurance even after experiencing a series of losses over time. On the contrary, to make money with an unplanned approach that realizes a Reward/Risk ratio of less than 1:1 would require an extremely high Win/Loss ratio, which may be difficult to maintain over time. In the latter scenario, when the trader hits the unavoidable bad stretch and loses several consecutive trades, emotional stress and lack of confidence can then easily take their toll resulting in even worse tendencies, like over-trading.

The following table shows the profitability impact of a low Reward/Risk system (in this example, risking 20 pips to make 20 pips). As you can see, the breakeven point in this system occurs at a much higher win ratio (50%), and the highest Average Net of 20 pips per trade requires a 100% win ratio, whereas with a 3:1 ratio as shown in the table above, a win ratio of less than 40% could produce the same Average Net. In other words, a high Reward/Risk trading system is much more forgiving of failures than is a low Reward/Risk trading system.

With this in mind, it's time for you to determine your trading system to approach the market.