Whether you’re new to trading or more experienced, it’s likely you’ll have lots of questions along the way - from what your maximum drawdown figure should be to deciding on a good risk-reward ratio.
Here are some of the most common trading questions answered - part one will look at risk-reward ratios, drawdown figures, percentage swings and RSI.
4 Most Popular Trading FAQs Answered: Part One
1. What should my risk-reward ratio be?
Your risk-reward ratio is one of the first elements you should incorporate into your trading plan. Put simply, a risk-reward ratio measures the difference between the profit potential of a trade relative to its loss potential.
How is risk-reward calculated? For example, if you buy a stock at $15.60, places a stop loss at $15.50 and a profit target at $15.85, then the risk on the trade is $0.10 ($15.60 - $15.50) and the profit potential is $0.25 ($15.85 - $15.60).
The risk is then compared to the profit to create the ratio: risk/reward = $0.10 / $0.25 = 0.4. If the ratio is greater than 1.0, the risk is greater than the profit potential on the trade. If the ratio is less than 1.0, the profit potential is greater than the risk.
So - what should your risk-reward ratio be? It’s a personal choice that will depend on your available capital and how much you are willing to risk, but it’s generally recommended that you risk no more than 1-2% of your capital per trade. Any more than 4 or 5% is considered high risk, so it’s best avoided if possible! Generally speaking, a good risk reward ratio is usually anything greater than 1 in 3.
2. What should my maximum drawdown figure be?
When you lose money on trades, this is referred to as drawdown. It’s the difference between a high point in the balance of your trading account and the next low point of your account’s balance.
Similarly to calculating your risk-reward ratio, each trader’s maximum drawdown figures will be different depending on their personal capital and how much they are willing to risk.
At BluFX, we’d recommend that your drawdown is no more than 10% - when it reaches this level, it’s a good idea to consider taking a break from trading or reducing your trading size.
3. What should my percentage swing be?
In volatile markets, using the percentage swing method is a good way to get clear signals for entering and exiting a trade. So - what should your percentage swing be?
This is dependent on how much you want to risk as well as on different degrees of entry and exit change. It’s all about balance: a percentage not too high and not too low - we’d recommend a percentage swing of around 5 or 10%. If it’s too low, you may enter the trade too soon, or if it’s too high you might not enter the trade in time.
It’s important to note that percentage swing should not be used alone but as part of other signals - such as candle formations, elliott waves and other technical indicators. We’d recommend trying out a variety of different percentages and adjusting your percentage swing figure in your trading plan accordingly to see what you find the most effective.
4. How should I interpret the RSI?
The RSI (Relative Strength Index) is a momentum indicator - and its movement is contained between 0 and 100. The RSI measures recent price changes to evaluate overbought or oversold conditions in the price of a stock.
So - what do RSI values mean and how can you use these while making trading decisions?
- Values of 70 or above suggest that an asset is being overbought or overvalued and indicate that there may be a trend reversal where the price weakens.
- Values of 30 or below suggest an oversold or undervalued condition and indicate that the price may strengthen.
Some traders see assets of 30 or below as an opportunity to buy, while values of 70 or above generally indicate an opportunity to sell.
RSI is usually used to confirm price action patterns and to trigger buy or sell signals.
Got more questions? Visit our BluFX FAQs page.