How To Filter Trades Like An Expert Trader (Money & Risk Management Trading Strategy for Beginners)
By: Calvill Joseph
Tags: Investing, Forex, Trading, Forex Trading

How To Filter Trades Like An Expert Trader (Money & Risk Management Trading Strategy for Beginners) Calvill Joseph Apr 25·7 min read

Successful traders are aware of the risk they

will take on each trade and the reward they

will receive prior to executing a transaction.

At its very core, the implications of risk

and reward in trading are very simple.

You objectively evaluate the amount of capital

you wish to expose and evaluate the potential

for reward against the risked capital.

Ideally, a trade should only be executed when

the anticipated gain or reward from the trade

matches or exceeds the risk being taken.

But is not that simple.

In today’s article I will share how I filter

trades based on risk & reward using price

action, so that you can protect and gradually

increase your trading account.

it is fairly common to see traders often complicating

the perspective of risk and reward leading

to complex and often bad decision making in

their trading.

A primary reason has to do with the subjective

nature of the “reward” element of the

analysis.

So let’s discuss about each of them.

First, let’s address the “risk” factor

in your trading.

This is relatively easier and a rather objective

task for a trader to determine the portion

of capital to be risked on a trade.

For most traders, it is usually a fixed percentage

of their capital, for example 1% or 2% per

trade.

For some advanced traders who understand the

varying probability of success for different

trade setups, the risk factor could be defined

in a range.

For example, from 0.5% for an aggressive trade

setup to 1% or 1.5% for more conservative

higher probability trades.

Obviously, there will be other factors to

consider as well like the frequency of trading,

your individual risk appetite, nature of trading

and access to capital, meaning how much money

you have at your disposal for trading or investing.

But no matter how many factors you put in

this subject, the aspect of determining you

risk per trade is usually a straightforward

process that you are usually able to figure

out with some basic trial and error.

Now let’s consider the perspective of Reward

factor, which is usually the bigger problem

for most traders who struggle with using risk

and reward effectively in their trading.

The reason the reward aspect gets tricky is

because it is virtually impossible for a trader

to determine beforehand what the outcome on

the trade will be, hence making it technically

impossible to arrive at an objective risk

to reward ratio for a trade setup.

An example would be entering the market with

1% risk and closing the trade out at a 2%

reward.

But such methods are usually used by traders

who don’t use market developments and price

action as a core principle for their exit

strategy.

We are better that than, so we’ll set our

reward based on price.

So how can a trader safely assume a particular

risk to reward ratio on a trade?

There are 2 simple techniques.

A common method that is often successfully

implemented by traders is using the “first

support/resistance area” approach.

As the name itself suggests, the first support/resistance

area for a trade would be the closest level

that the trader believes could possibly hold

price resulting — in the worst case — in

a bounce off that level, threatening the viability

of the trade idea.

This approach calls for the trader to assume

a conservative outcome for the trade — that

is the market will bounce from that area.

Assuming that in a situation like this, you

would take action to close out the trade,

you could employ the distance from the entry

to this first support/resistance area to arrive

at an optimal risk reward ratio for your trade.

This example illustrates the first support/resistance

area approach.

Let’s consider you want to sell at the close

of this bearish pin bar candlestick pattern,

with a stop loss above the high of the pin

bar and the first support/resistance area

being used to evaluate a conservative reward

value for the trade.

This region represents the risk on the trade,

and this one represents the potential reward.

By comparing the areas based on the first

support/resistance area approach, we see that

the setup is yielding a near 1:1 risk: reward

ratio.

You can observe that the market actually pushed

a little lower than the first support/resistance

area.

But that’s irrelevant, because the conservative

exit occurred right at first support/resistance

area.

Now, very important, the general problem that

traders often face with this approach is that

the first support/resistance area will usually

not be far enough to result in a 1:1 or better

risk: reward ratio.

If you find yourself in a similar setup, and

the reward is lower than the risk, skip the

trade.

Now, let’s consider an alternate approach

that does provide a bit more flexibility to

the trader, and that is the major support/resistance

area.

For particular trades, a trader might be confident

of a move further away from the first support/resistance

area, possibly because of the strength of

the setup, which should ideally reflect in

the risk to reward ratio.

This approach calls for the trader to calculate

the distance between the entry and a “major”

support/resistance area that he anticipates

price to be reacting at.

The major support/resistance area could be

the first support/resistance area or an upcoming

important area further away past the minor

support/resistance areas.

So let’s take an example to demonstrate

this approach.

In this case, the trader is now looking past

the first support/resistance area towards

the major support/resistance area, as shown

here.

Assuming the same setup and trading plan,

you will notice how the reward area is now

noticeably larger than the risk area, thereby

yielding a risk: reward ratio better than

1:1.

The market did actually make it to the major

support/resistance area, and in this case

the second approach would have worked better.

The advantage here is a more realistic risk

to reward ratio that accounts for a trader’s

own expectations of the outcome of the trade.

However, on the flipside, it also requires

sound judgment from the trader.

For newer traders, this can be hard to achieve

as every trade taken is normally expected

to perform very well, mainly as a result of

emotions rather than concrete evidence driven

from prevailing market conditions.

For these traders, following such a strategy

will often result in artificially attractive

risk to reward ratios that are not very useful.

So, how do you find a R:R ratio that works

for you?

As a general recommendation, it would be wise

for newer traders to begin with more conservative

measures of risk to reward ratios as determined

by the first support/resistance area approach

and gradually, with experience and the resulting

confidence, you could adopt the advanced major

support/resistance area approach for a more

realistic measure.

While there’s no Holy Grail to finding the

perfect reward-to-risk ratio, a good place

to start is to look at your win rate.

Before you can expect your risk ratio to work

for you, you must first confirm that you CAN

win often enough to eventually hit that potential

reward.

For example, using a 1:1 risk ratio means

that your potential profit is as big as your

potential loss.

This will only work out if you’re right

AT LEAST half the time historically.

Bear in mind that a risk to reward ratio of

1:1 means nothing and depends on expected

trade outcomes.

It is therefore more logical to be using a

strategy that allows you to arrive at realistic

numbers even if it means having to pass on

a trade setup due to a low risk: reward.

A healthy mindset is to avoid being optimistic

when you get into a trade.

A common mistake many traders make is that

they pick a very distant take profit level

or use a stop loss that is too tight just

to create a larger risk: reward ratio.

Of course, this leads to several problems:

first, price can’t reach the overly optimistic

target levels and you give back profits and,

secondly, price takes out the too conservative

stop loss and then continues onto your initial

profit level, but leaving you with nothing

behind.

In both cases, the trader has created the

illusion of a potentially lucrative trade.

Very often, traders use a large potential

ratio to reason themselves into a trade they

shouldn’t be in and they take the potential

large payoff as an excuse to bend their trading

rules.

Before you are about to enter a trade, pause

for a few moments and make sure that you have

set your orders in a realistic way, based

on price action and you are not violating

your rules.

Always remember that reward ratio must based

on market context and has to change on a trade

to trade basis.

Traders often try to use shortcuts and set

fixed rules for their take profit and stop

loss orders to come up with the same risk:

reward ratio every time.

However, the way you place your profit and

stop orders has to change based on the chart

context.

If price is about to run into a support area,

you should consider setting your profit target

ahead of the level and reduce the likelihood

of price missing your target; if price is

near a resistance level, you can set your

stop at the other side to add another barrier

between price and your stop.

Always using the same amount of points for

your stop can quickly lead to problems when

you don’t take support/resistance or other

chart factors into context.

Also, when you don’t adjust your profit

target based on the price chart in front of

you, you can easily make the mistake of placing

the order at strategic bad and hard to reach

areas.

Thus, instead of using a fixed risk: reward

ratio with fixed rules for your stop and target,

work with a risk: reward ratio threshold instead

and adjust your orders based on the current

price charts and the price context.

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