The Myth Of Profit/Loss Ratios

When trading the forex market or other markets, we are often told of a common money management strategy that requires that the average profit be more than the average loss per trade. It's easy to assume that something that has been so widely advised must be a good thing. However, if we take a deeper look at the relationship between profit and loss, it is clear that the "old," commonly-held ideas may need to be adjusted.

What’s Profit/Loss Ratio
A profit/loss ratio refers to the size of the average profit compared to the size of the average loss per trade. For example, if your expected profit is $900 and your expected loss is $300 for a particular trade, your profit/loss ratio is 3:1 - which is $900 divided by $300.

Many trading books and "gurus" advocate a profit/loss ratio of at least 2:1 or 3:1, which means that for every $200 or $300 you make per trade, your potential loss should be capped at $100.

At first glance, most people would agree with this recommendation. After all, shouldn't any potential loss be kept as small as possible and any potential profit be as much as possible? The answer is: not always. In fact, this common piece of advice can be misleading, and can cause harm to your trading account.

The blanket advice of having a profit/loss ratio of at least 2:1 or 3:1 per trade is over-simplistic because it does not take into account the practical realities of the forex market (or any other markets), the individual's trading style and the individual's average profitability per trade (APPT) factor, which is also referred to as statistical expectancy.

APPT is Key to Profitability
Average profitability per trade basically refers to the average amount you can expect to win or lose per trade. Most people are so focused on either balancing their profit/loss ratios or on the accuracy of their trading approach that they are unaware that a bigger picture exists: Your trading performance depends largely on your APPT.

This is the formula for average profitability per trade:

Average Profitability Per Trade = (Probability of Win x Average Win) - (Probability of Loss x Average Loss)

Let's explore the APPT of the following hypothetical scenarios:

Scenario A:
Let's say that out of 10 trades you place, you profit on three of them and you realize a loss on seven. Your probability of a win is thus 30% or 0.3, while your probability of loss is 70% or 0.7. Your average winning trade makes $600 and your average loss is $300.

In this scenario, the APPT is:
(0.3 x $600) – (0.7 x $300) = - $30
As you can see, the APPT is a negative number, meaning that for every trade you place, you are likely to lose $30. That's a losing proposition!

Even though the profit/loss ratio is 2:1, this trading approach produces winning trades only 30% of the time, which negates the supposed benefit of having a 2:1 profit/loss ratio.

Scenario B:
Now let's explore the APPT of a trading approach that has a profit/loss ratio of 1:3, but has more winning trades than losing ones. Let's say out of the 10 trades you place, you make profit on eight of them, and you realize a loss on two trades.

Here is the APPT:
(0.8 x $100) – (0.2 x $300) = $20

In this case, even though this trading approach has a profit/loss ratio of 1:3, the APPT is positive, which means you can be profitable over time.

Many Ways of Becoming Profitable
When trading the forex market, there is no one-size-fits-all money management or trading approach. Traditional advice, such as making sure your profit is more than your loss per absolute trade, does not have much substantial value in the real trading world unless you have a high probability of realizing a winning trade. What matters is that your APPT comes up positive and that your overall profits are more than your overall losses.

Source from:investopedia.com

What’s The Risk Of Forex Trading

Factors such as the size, volatility as well as global structure of the foreign exchange market all contribute to its rapid success. But while the forex market may offer more excitement to the investor, the risks are also higher in comparison to trading equities. The ultra-high leverage of the forex market means that huge gains can quickly turn to damaging losses and can wipe out the majority of your account in a matter of minutes. This is important for all new traders to understand, considering the risks involved in the forex market before diving in.

In the forex market, due to the large amount of money involved and the number of players - traders will react quickly to information released into the market, leading to sharp moves in the price of the currency pair.

Though currencies don't tend to move as sharply as equities on a percentage basis (where a company's stock can lose a large portion of its value in a matter of minutes after a bad announcement), it is the leverage in the spot market that creates the volatility. For example, if you are using 100:1 leverage on $1,000 invested, you control $100,000 in capital. If you put $100,000 into a currency and the currency's price moves 1% against you, the value of the capital will have decreased to $99,000 - a loss of $1,000, or all of your invested capital, representing a 100% loss. In the equities market, most traders do not use leverage, therefore a 1% loss in the stock's value on a $1,000 investment, would only mean a loss of $10. Therefore, it is important to take into account the risks involved in the forex market before diving in.

Players of the Forex Market

Unlike the equity market - where investors often only trade with institutional investors (such as mutual funds) or other individual investors - there are additional participants that trade on the forex market for entirely different reasons than those on the equity market. Therefore, it is important to identify and understand the roles and motivations of the main players of the forex market.

Governments and Central Banks
Arguably, some of the most influential participants involved with currency exchange are the central banks and federal governments. In most countries, the central bank is an extension of the government and conducts its policy in tandem with the government. However, some governments feel that a more independent central bank would be more effective in balancing the goals of curbing inflation and keeping interest rates low, which tends to increase economic growth. Regardless of the degree of independence that a central bank possesses, government representatives typically have regular consultations with central bank representatives to discuss monetary policy. Thus, central banks and governments are usually on the same page when it comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at its target exchange rate. Central banks use the foreign exchange market to adjust their reserve volumes. With extremely deep pockets, they yield significant influence on the currency markets.

Banks and Other Financial Institutions
In addition to central banks and governments, some of the largest participants involved with forex transactions are banks. Most individuals who need foreign currency for small-scale transactions deal with neighborhood banks. However, individual transactions pale in comparison to the volumes that are traded in the interbank market.

The interbank market is the market through which large banks transact with each other and determine the currency price that individual traders see on their trading platforms. These banks transact with each other on electronic brokering systems that are based upon credit. Only banks that have credit relationships with each other can engage in transactions. The larger the bank, the more credit relationships it has and the better the pricing it can access for its customers. The smaller the bank, the less credit relationships it has and the lower the priority it has on the pricing scale.

Banks, in general, act as dealers in the sense that they are willing to buy/sell a currency at the bid/ask price. One way that banks make money on the forex market is by exchanging currency at a premium to the price they paid to obtain it. Since the forex market is a decentralized market, it is common to see different banks with slightly different exchange rates for the same currency.

Hedgers
Some of the biggest clients of these banks are businesses that deal with international transactions. Whether a business is selling to an international client or buying from an international supplier, it will need to deal with the volatility of fluctuating currencies.

If there is one thing that management (and shareholders) detest, it is uncertainty. Having to deal with foreign-exchange risk is a big problem for many multinationals. For example, suppose that a German company orders some equipment from a Japanese manufacturer to be paid in yen one year from now. Since the exchange rate can fluctuate wildly over an entire year, the German company has no way of knowing whether it will end up paying more euros at the time of delivery.

One choice that a business can make to reduce the uncertainty of foreign-exchange risk is to go into the spot market and make an immediate transaction for the foreign currency that they need.

Unfortunately, businesses may not have enough cash on hand to make spot transactions or may not want to hold massive amounts of foreign currency for long periods of time. Therefore, businesses quite frequently employ hedging strategies in order to lock in a specific exchange rate for the future or to remove all sources of exchange-rate risk for that transaction.

For example, if a European company wants to import steel from the U.S., it would have to pay in U.S. dollars. If the price of the euro falls against the dollar before payment is made, the European company will realize a financial loss. As such, it could enter into a contract that locked in the current exchange rate to eliminate the risk of dealing in U.S. dollars. These contracts could be either forwards or futures contracts.

Speculators
Another class of market participants involved with foreign exchange-related transactions is speculators. Rather than hedging against movement in exchange rates or exchanging currency to fund international transactions, speculators attempt to make money by taking advantage of fluctuating exchange-rate levels.

The most famous of all currency speculators is probably George Soros. The billionaire hedge fund manager is most famous for speculating on the decline of the British pound, a move that earned $1.1 billion in less than a month. On the other hand, Nick Leeson, a derivatives trader with England’s Barings Bank, took speculative positions on futures contracts in yen that resulted in losses amounting to more than $1.4 billion, which led to the collapse of the company.

Some of the largest and most controversial speculators on the forex market are hedge funds, which are essentially unregulated funds that employ unconventional investment strategies in order to reap large returns. Think of them as mutual funds on steroids. Hedge funds are the favorite whipping boys of many a central banker. Given that they can place such massive bets, they can have a major effect on a country’s currency and economy. Some critics blamed hedge funds for the Asian currency crisis of the late 1990s, but others have pointed out that the real problem was the ineptness of Asian central bankers. Either way, speculators can have a big sway on the currency markets, particularly big ones.

Biggest Market In The World --- Forex Trading Market

What’s the biggest market in the world? That’s the forex market. In order to conduct foreign trade and business, currencies need to be exchanged. A French tourist in Egypt can't pay in euros to see the pyramids because it's not the locally accepted currency. As such, the tourist has to exchange the euros for the local currency.

The need to exchange currencies is the primary reason why the forex market is the largest, most liquid financial market in the world. It dwarfs other markets in size, even the stock market, with an average traded value of around U.S. $2,000 billion per day. (The total volume changes all the time, but as of April 2004, the Bank for International Settlements (BIS) reported that the forex market traded U.S. $1,900 billion per day.)

The Forex market is a non-stop cash market where currencies of nations are traded, typically via brokers. Foreign currencies are constantly and simultaneously bought and sold across local and global markets and traders' investments increase or decrease in value based upon currency movements. Foreign exchange market conditions can change at any time in response to real-time events.

The main enticements of currency trading to private investors and attractions for short-term Forex trading are:

§ 24-hour trading, 5 and a half days a week with non-stop access to global Forex dealers. When the trading day in the U.S. ends, the forex market begins anew in Tokyo and Hong Kong. The forex market can be extremely active any time of the day, with price quotes changing constantly.
§ An enormous liquid market making it easy to trade most currencies. Currency trading is conducted electronically over-the-counter (OTC), which means that all transactions occur via computer networks between traders around the world, rather than on one centralized exchange.
§ Volatile markets offering profit opportunities.
§ Standard instruments for controlling risk exposure.
§ The ability to profit in rising or falling markets.
§ Leveraged trading with low margin requirements.
§ Many options for zero commission trading.


Spot Market and the Forwards and Futures Markets
There are actually three ways that institutions, corporations and individuals trade forex: the spot market, the forwards market and the futures market. The forex trading in the spot market always has been the largest market because it is the "underlying" real asset that the forwards and futures markets are based on. In the past, the futures market was the most popular venue for traders because it was available to individual investors for a longer period of time. However, with the advent of electronic trading, the spot market has witnessed a huge surge in activity and now surpasses the futures market as the preferred trading market for individual investors and speculators. When people refer to the forex market, they usually are referring to the spot market. The forwards and futures markets tend to be more popular with companies that need to hedge their foreign exchange risks out to a specific date in the future.

What is the spot market?
More specifically, the spot market is where currencies are bought and sold according to the current price. That price, determined by supply and demand, is a reflection of many things, including current interest rates, economic performance, sentiment towards ongoing political situations (both locally and internationally), as well as the perception of the future performance of one currency against another. When a deal is finalized, this is known as a "spot deal". It is a bilateral transaction by which one party delivers an agreed-upon currency amount to the counter party and receives a specified amount of another currency at the agreed-upon exchange rate value. After a position is closed, the settlement is in cash. Although the spot market is commonly known as one that deals with transactions in the present (rather than the future), these trades actually take two days for settlement.

What are the forwards and futures markets?
Unlike the spot market, the forwards and futures markets do not trade actual currencies. Instead they deal in contracts that represent claims to a certain currency type, a specific price per unit and a future date for settlement.

In the forwards market, contracts are bought and sold OTC between two parties, who determine the terms of the agreement between themselves.

In the futures market, futures contracts are bought and sold based upon a standard size and settlement date on public commodities markets, such as the Chicago Mercantile Exchange. In the U.S., the National Futures Association regulates the futures market. Futures contracts have specific details, including the number of units being traded, delivery and settlement dates, and minimum price increments that cannot be customized. The exchange acts as a counterpart to the trader, providing clearance and settlement.

Both types of contracts are binding and are typically settled for cash for the exchange in question upon expiry, although contracts can also be bought and sold before they expire. The forwards and futures markets can offer protection against risk when trading currencies. Usually, big international corporations use these markets in order to hedge against future exchange rate fluctuations, but speculators take part in these markets as well.

Note that you'll see the terms: FX, forex, foreign-exchange market and currency market. These terms are synonymous and all refer to the forex market.