At it’s essence, trading foreign exchange rates profitably is all about picking out high probability trading setups. Understand probabilities within the context of your everyday trading, and most of your trades will be winners – with a favourable risk/reward ratio to boot. That’s a powerful duo to have on your side.
In this article we figure out poignant ways to help you understand and trade high probability scenarios.
Understanding Probability When Trading Foreign Exchange Rates
When we toss a coin up in the air, there’s pretty much a 50/50 chance it will land on heads or tails. When you place a ball in one hand and hide them behind your back – a friend has a 50/50 chance of guessing within which hand the ball is grasped. 50/50 might be ok for the ball game, but it’s just not going to cut it when it comes to growing your trading capital. To do this, we need to better understand risk and identify good risk vs reward scenarios. Consider the following:
1. The Simple Concept Of Risk Vs Reward Has The Power To Turn Your Trading Upside Down. Many newbie traders with a poor education don’t quite get the importance of picking purely high probability foreign exchange rates trading plays. Consider this scenario and state which one you would rather choose as a trader:
(a) A trade where your target profit is 60 pips and your stop loss is 20 pips.
(b) A trade where your target profit is 20 pips and your stop loss is 60 pips.
Of course, you would want the scenario where you risk 20 pips to gain 60. To risk 60 pips in order to gain 20 would be suicidal to your equity in the long run. You would need 3 profitable trades just to offset the loss made by each loser. That sort of risk versus reward is terrible, yet many inexperienced traders open positions such as these all the time.
2. How Can We Identify Our Risk Versus Reward? Whenever we analyse a potential trade, as good traders we must always come up with a stop loss and a take profit target. The stop loss represents our risk – this is the point at which we would exit out the trade at a loss. The take profit point represents our reward – this is the price at which we close our trade for a profit. Ideally, we would always want our take profit target to be substantially higher, by way of pips, than our stop loss. Anything else would be illogical.
3. An Example Of A Foreign Exchange Rates Trade With Good Probability. Let’s examine a simple example that is actually quite abundantly available to trade. Let’s assume that EUR/USD has been ranging between a support and resistance level quite predictably and the price has come back to the support region. The support is at 1.2050 and the resistance has been sitting at a lofty 1.2250. The current price is at 1.2070 and seems to be trending back up towards resistance. In many ways this is an ideal high probability trading setup. If we were to go long, we could set our stop loss a few pips below the current support (let us say at 1.2040). We could also set our take profit at 1.2230 – marginally below the known resistance. The reason this is a high probability set up is as follows:
- The price appears to be trending back up, and so respecting the trading range pattern. You would need to of course confirm this by way of your favourite indicators.
- Our risk is 30 pips – this is the difference between the existing price and the stop loss we set.
- Our reward is 160 pips which is the difference between the current price and our take profit target.
- Were you to confine your trading to high probability setups like this, where you risk 30 pips to retrieve 160, you would become a very profitable trader very quickly!