There are certain skills that you will need to succeed in the forex market. Most guides and articles on the internet focus on the emotional discipline that a trader needs to cope with the ups and downs that fluctuating foreign exchange rates can bring in a trader’s career.
However, one of the qualities that most teachers, mentors, and experts seem to take for granted in a forex trader is his ability with numbers. What this means is that mathematical ability is extremely crucial to the success of a forex trader.
In fact, all successful traders that you may have heard about have this in common amongst them. Therefore, if you truly want to succeed in making money out of foreign exchange rate fluctuations then you need to learn when, where, and how to use your calculating abilities. Consider the following.
Minimum Dollar Risks
The first thing you need to calculate is how large a financial hit you can take on each trade that you place in the market. This number needs to be calculated in terms of money as opposed to pips.
In order to calculate this, you will need to create a series of losses wherein you lose a fixed amount of money on each trade through fluctuations in foreign exchange rates. The combined impact of these losses should not exceed more than 25 percent of your total account equity.
The reason for this is simply that if your account equity goes down below 75 percent then you will find it very difficult to recoup those losses. For instance, if you lose 50 percent of your account equity then you will need to make 100 percent of what you have left in profits to break even.
Making these calculations will also allow you to know the maximum drawdown that your account can take.
Risk to Reward Ratios
You will have to treat each trade on its merit. The merit of each trade needs to be calculated in terms of its risk to reward ratio. This ratio would essentially have two components. This is the amount of money you stand to lose from foreign exchange rates’ fluctuations and the amount of money you stand to gain from them.
The reason why calculating this ratio is important is that it is inevitable that you will incur losses in the market. Every trader, no matter how talented, incurs losses at regular intervals because it is impossible to project foreign exchange rates’ movements 100 percent of the time.
If you accept that there will be losses then the risk to reward ratios you calculate will allow you to ensure that your net results are in the black as opposed to being in the red.
Your position sizes need to be calculated on the basis of all the aspects mentioned above i.e. risks, rewards, dollar risk per trade, and maximum drawdown. Basing your calculations on these aspects of trading foreign exchange rates will help you come up with position sizes that are most suitable for your forex trading efforts.