Trading the Forex market is risky. Everyone knows that. In fact, investing is risky. When going in the market with the idea of making a return, the first thing to look for is not how much you will make, but how to protect your investment.
To be more exact, managing the risk is far more important than one single trade. If you go into the Forex market with the idea that all trades must be winners, you’ll fail.
You must accept that losses are part of the trading process. The idea is to have more winners than losers. However; you can have more losers if the winners are bigger in terms of the pips made and the value of those pips.
For example, you can have a losing trade that generated one percent drawdown in your trading account. And this repeats for ten times in a row. However, if a losing trade has a risk-reward ratio of 1:10 or higher, and you risk one percent on every trade, you’ll still end up being profitable.
Now, this is an extreme example. In Forex trading, we need to look for realistic targets. A common risk-reward ratio for the Forex market is somewhere between 1:2 and 1:2.
This is because the market spends most of the time in consolidation, or in ranges. These ranges can be bigger in some pairs, smaller in others, but still, ranges.
Scaling in a Trade
As mentioned above, money management is the key to growing an account in time. Depending on the strategy used, a sound money management system must have:
– The trading volume based on the initial deposit.
– The risk-reward ratio to be used.
– Clear levels for entry, stop loss and take profit.
– Clear steps to compound on your gains.
In Forex trading, to scale in a position it means to take multiple entries with the idea of having a better average for your trade. However, as part of a money management system, this can only work if you split the volume in a trade while keeping the same risk.
Otherwise, you’ll end up overtrading that account. This is something one needs to avoid at all costs.
Money Management Scaling
Let’s assume you have a trading system you tested and it stood the test of time. This means in demo and back-testing, results look promising. It is time to see how the system performs in real conditions.
Moving forward, assuming a $5000 initial founding. The risk for any trade is one percent of the trading account. The reward is 1:2 and initial trading volume is 0.2 lots. In time, with the account growing, the trading volume increases. Or, it decreases with every losing trade.
To sum up the above conditions, you’ll risk one percent of your account for two percent reward. Literally, you should be stopped at $50 or exit when you make a hundred bucks.
So far, so good. The first trade is to long or short a currency pair, 0.2 lots, risking $50 for $100. These conditions result from the money management system you must follow at all costs.
However, quick math shows that on the EURUSD pair, $50 on 0.2 lots represent around twenty-five pips for your stop loss and fifty for your take profit. This is too small for a trade on the hourly time frame or above.
Therefore, you need a bigger stop loss. But you cannot risk more than $50, as this is one percent of the trading account, remember?
The answer comes from scaling. What you need to do is to adjust the volume of your trade in such a way that you’ll gain leverage against the stop needed.
For example, if your trading strategy needs a stop loss of fifty pips. What would you do in this case? The answer is you trade 0.1 lots, place the stop loss at fifty pips and go for a hundred pips take profit.
You just scaled according to your money management rules. This way, even if your stop gets triggered, you’ll still lose only one percent of your account and make two percent if your trade ends up being a winner.
Typically, you’ll find out that scaling has a different definition; split the trading volume in different entries to gain a better average. However, this is difficult to do in a money management system that has restrictions regarding the risk involved.
Not that is impossible. One way is to use the example provided in this article, adjusting the volume, and not the entry levels.
If you insist on doing the classical scaling, you’ll end up splitting the volume into as many parts as you want to scale in, and then risking the same proportion of your account. The result is the same in the end, but the first approach is easier to implement.