Boldly Taking Calculated Risks

My two rules of investing: Rule one – never lose money. Rule two – never forget rule one.

-Warren Buffett

Investing can be seen as a competitive activity, just like team sports. To triumph in a sporting event, it is vital to understand your opponent, size up their strengths and weaknesses and eventually build a strategy to defeat them. Trading is no different. Evaluating the financial asset, understanding its past performance and using this information to build a strategy forms the cornerstone of a potentially successful investment.

Why Not Losing is Just as Important as Winning

One of the most important concepts in investing is that “you can’t get hurt taking profits”. The meaning here is simple: realising a gain from a trade in no way, shape or form hurts you and your trading account. What does hurt, however, is realizing a large loss - especially if it was entirely preventable and avoidable.

Investing is no different from being a hero in a movie – sometimes one must retreat from battle to fight another day. Becoming too attached to an idea or a certain bias can cloud our judgment and prevent us from taking advantage of other unfolding opportunities. Ultimately, we always want to come back and trade another day.

Taking outsized risks relative to the potential reward for a trade opportunity tilts the equation towards risk, limiting our potential benefits. By risking everything on a single idea, trading capital can be wiped out with one wrong move. Carefully setting limits for your trades, sticking to rules such as not allocating more than 10% of your trading capital to a single idea, and understanding the consequences of a negative trade outcome are key for identifying the risks involved in a trade.

Defining how much you are willing to lose for a potentially profitable outcome forms the basis for defining the accompanying risk-reward conditions of a trade.

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How Often do the Professionals Make Winning Trades?

How often do you think professional investors place successful trades? 90% of the time? 70% of the time? 50% of the time? The actual success rate will surprise you. It is estimated that the most seasoned professionals only place winning trades about 30% of the time. So, how do they stay profitable over time? Simply put, they take calculated risks where the reward side of a trade always exceeds the possible risks. Let’s look at a simple example to put this idea in perspective.

If we were to open a position where we risk $1.00 of loss for $3.00 of potential profit, our risk-reward ratio would look like 1:3. Let’s assume we make 10 trades, each with the same amount of capital and the same upside and downside potential. If we make 3 winning trades, we expect to generate a profit of $9.00 ($3.00 x 3 winning trades). From the remaining 7 losing trades, we would lose $7.00 ($1.00 x 7 losing trades). Therefore, our expected return from 10 trades with the same risk-reward profile would be $2.00.

If we adjust the risk-reward ratio to 1:2, the expected value of our 10 trades is negative in this case, with an expected return of -$1.00 ($2.00 x 3 - $1.00 x 7). The most important takeaway from this example on risk-reward ratios is as follows: the reward from a trade must always overcompensate us for the risks we are taking.

Planning for Success Begins with Preparing for Failure

Building a strategy and planning its execution is the first place to start when considering a trading opportunity. It boils down to having a reason to get involved, understanding the risk and determining the potential reward of a strategy, identifying an area or level to enter the trade and defining where to exit - either in a winning or losing scenario.

An easy way to visualize how this works is by opening an FXTM Cent Account to access the platform’s complimentary trading signals. Each FXTM Trading Signal is designed to provide users with several scenarios which outline an entry point for a trade, target levels for taking profits and a stop-loss level. Apart from highlighting and planning for the different scenarios that might unfold, this helpful tool is especially useful for understanding how to setup a trade and how to react if an asset moves in your favour or against you.

Successful trading over the long term depends on cutting your losses quickly, and being sensible about taking profits instead of becoming greedy. By calculating the risk of entering a trade and ensuring that the rewards will adequately compensate you for the risks you are taking, you can always be prepared to address both the best- and worst-case scenarios - no matter which one unfolds.

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