It is of great importance to understand and apply the factors that influence your level of profitability in Forex trading if you want to earn the optimal return on your trading efforts.
Some of these factors that we will now discuss have a direct effect on profitability, e.g. if the specific factor is doubled the profits will also be doubled, and other factors have an exponential effect on profits, which could quadruple profits if the specific factor is doubled.
The situation is somewhat complicated by the fact that these factors normally do not operate independently, but are influenced by, or have influence on, other factors. This means that most of the time one has to find the optimal trade off between two or more than one of these factors.
Let us look first at the factors that have a DIRECT influence on your profits:
- Lot Size – also determined by:
- Equity or Account Balance
- Risk percentage
- Stop Loss
Lot size should be determined by your maximum risk factor, e.g. 2% of equity or account balance, the size of your Stop Loss and the amount of your equity or account balance. Therefore if you double your risk to 4%, or double your account balance, or cut your Stop Loss by 50% you will also double your profits.
So for example if you have an account balance of $5000 and you take a maximum risk per trade of 2% and your Stop Loss is 50 pips, your lot size should be 0.2 – or two mini lots. If you trade on a 1:1 Risk : Reward you will make a profit of 50 pips x 0.2 = $50. Now double your risk % OR account balance OR halve your Stop Loss to 25 pips, and your profit will be doubled to $100 – a direct relationship.
Now, of course, if you double your risk or halve your Stop Loss you may experience greater losses, so that is why it is better to look at rather increasing your account balance / equity if you want to increase your profits. You risk should preferably be fixed at a certain percentage and your Stop Loss should be determined by the system you trade, volatility, etc.
- Number of trades per month
Obviously if you are taking 100 trades per month and have a 70% win rate, you can double your profits if you double the number of trades trades to 200 trades per month – IF you keep to the same win rate. This is only going to be true if the quality of the trades taken overall stays the same. You can try to achieve this by trading more currency pairs, but if the quality of your trades is compromised by forcing additional trades to increase the number of trades per month you will not enjoy the direct doubling of your profits as expected. So if your winning percentage was 70% when having the 100 trades per month, and now the winning percentage is reduced to 60% when you are taking 200 trades per month the objective will not be achieved, since the net profit will be the same as with the 100 trades at a 70% win rate.
Now let us look at the factors that have an EXPONENTIAL effect on your profitability:
3. Risk : Reward
We will define “Risk” as equal to the size of the Stop Loss, and “Reward” as equal to the size of the Take Profit. That means if you have a 1:1 Risk : Reward your Stop Loss and Take profit is equal in size. Now if we double the Risk : Reward to 1:2 the profit will increase exponentially with 400% – IF the same win rate is maintained. And that is the crux of the matter. Normally when you increase the size of the Take Profit your win rate will be reduced because it is obviously more difficult to achieve a profit target of 100 pips than it is to achieve a target of 50 pips. So the optimal point will have to be found by juggling the Risk : Reward until the point of maximum profit is achieved. This will be different for different trading systems.
4. Win Percentage / Win Rate
The second factor that has an exponential effect on profitability is that of the win percentage, or also called the win rate, which measures the number of trades in profit out of the total trades taken as a percentage. By increasing the win percentage by e.g. only 10% you can increase your profits by 100% – in other words double your profits.
A higher win percentage can often be achieved by taking only the highest quality trades with the highest probability of being winners. This could mean a lower number of trades that are taken, which could influence your total profit for the month.
In the end it is required that one takes all these factors in consideration to find the optimal combination of factors that will deliver the highest profit. This will take some optimization in platform software like Metatrader 4 and will be different from system to system.
This article attempts to give some guidance of where you should look to increase your profitability.
Below is a table below to show how different combinations of these factors determine profitability.
|Capital||% Risk of Capital||Reward (Risk=1)||% Winning Trades||# of Trades / Month||Gross Profit / Month||Gross Loss / Month||Netto Profit / Month||% Growth / Month|
|The Effect of Improving Win Percentage|
|The Effect of Improving Risk : Reward|