Forex Trading Money Management Strategy
It has become a general opinion that how to increase the risk/reward ratio must be willing to lose the opportunity for profit. Increasing the reward level or reducing the stop loss from the value we have set is quite risky.
In other words, it is very risky to increase the reward level or reduce the stop loss from the value we have set. Of course, you can prove it yourself through the experience of your trading strategy. One of the most effective and quite popular ways to increase the risk/reward ratio while maintaining the probability of profit is to look at the price movements in the lower trading time frame, and see if there is still a logical opportunity to change the stop loss or profit target.
How to Increasing Risk Reward Ratio
The following is exemplified by GBP / USD on the daily chart. We will enter the market based on signals from engulfing candlestick setup patterns that occur, and at the same time determine the risk/reward ratio. Below is a brief explanation to recall the nature of the candlestick pattern:
The engulfing candlestick pattern consists of two bars where one bar ‘swallows’ (engulf) the other bar with a longer body candle. This engulfing pattern will be more valid if you have a short tail or no tail because a long tail reflects the uncertainty of the direction of price movement. Usually, traders set the validity of this pattern with the provisions of the tail length “bar that swallows” not more than 20% -25% of the total length of the body candle. This pattern implies a trend reversal. The signal to open short positions on the bearish engulfing pattern is more valid if it is formed in an uptrend, and conversely, the signal to buy is more valid if the pattern is formed in the downtrend. In addition, if formed at a high trading time frame such as a daily chart, this engulfing pattern will be more accurate.
Back to the example of GBP / USD daily (the following picture), it seems that the setup of engulfing candlestick patterns is quite valid as a signal to open short positions. Normally, the trader opens short positions after the second candlestick of the engulfing pattern is completed, with the stop loss level above the second highest candlestick level, and the safest profit target at the risk/ratio 1 level: 1. If we observe further price movements, target profit of +105 pips will be realized in two bars or approximately two days.
How to Determine Stop Loss
Now let’s observe the price and pattern movements at a lower trading time frame to find a better entry position or smaller but still logical stop loss. In this case, we will see an hourly time frame (H1) as follows:
Obviously, there is an uptrend price pattern, and after the trend line has been drawn, it appears that the price movement in the daily engulfing chart pattern has broken the trend line on this H1 chart (light blue circle), and has been retested by subsequent bars which strengthen downtrend direction. In addition, the next 3 bars after the trend break line show a triangle pattern (green triangle) which in this case implies a downtrend.
Well, let’s look at entry opportunities and the possibility of changing stop loss or profit targets so that our risk/reward ratio increases. After we compare it with the daily chart, we set not to change the entry level, but we change the stop loss above the trend line and the triangle pattern, or about 45 pips. So compared to just looking at the daily chart with a stop loss of 105 pips, now we can reduce the stop loss to 45 pips, and the fixed profit target is +105 pips (based on the daily chart). Thus we have increased the risk/reward ratio to more than 1: 2.
We can believe that this trade will remain safe because trading signals are quite valid when we enter the daily time frame, we only change the amount of stop-loss at the hourly time frame, and this is still logical. In addition, the broken trend line that has been retested at the 1 hour time frame and the triangle pattern that occurs indicates that the price will not reverse direction quickly.
In conclusion, we can increase the risk/reward ratio by looking at the pattern of price movements at a lower time frame, and by increasing the risk/reward ratio does not mean we have to increase the stop loss or reduce the probability of our profit.