Why do traders lose money? Is it about their system or strategy? Is it the way they act on their trades?

Unexpected losses will usually occur to the trader who is unprepared.

It can be crushing to a trader and their method when these losses take place and throw up all varieties of questions, such as ‘should I change my method?, ‘should I add or take away more indicators?’, ‘should I trade at a different time?’.

Once you understand the reasons why traders win and lose, then profitable trades can occur more and more consistently.

The Root of The Problem

Every trader wants profitable trades. Though the study suggests that traders had been good at searching for trading opportunities, their losses had been far higher than their gains. This is a huge problem.

If you have ever read any trading book, or articles or watched trading movies you will always see the identical recommendation “cut losses, let income run”.

This is a simple answer right? But, it is far from easy to accomplish in real trading and there is a human psychological reason for it.

The answer is simple, “human nature”. What if you were offered a simple card game? You have to choose one from both playing cards and you were given two choices.

Eg 1: Card A will make you $900 and Card B will give you a 90% chance of making $1000. Survey showed that most of the people will choose Card A which will guaranteed $900.

Eg 2: Card A will give you $900 loss and Card B will give you a 90% chance of losing $1000. Survey showed that now most people will take the risk and a 90% chance of losing $1000 instead of a guaranteed $900 loss.

It is human nature and psychology that makes trading complicated. We have interaction in risk to avoid pain or loss when logic and chances indicate different actions are far better for us.

The Prospect Theory – Trade For Results Not Feelings

The prospect theory is a behavioral economic theory that describes the preferences people make that entails risk and rewards, where the result is unpredictable.

Most people will take more pain from losses than the pleasures from gains. Think rationally and not emotionally. Treat a 50-point gain as equivalent to a 50-point loss. See the infographic above for more on how this works.

How to Avoid the Loss-Making Problem?

We can see from this study we need to gain more from our winners, than what we lose on our losers.

To do this correctly, comply with a strict rule of “seek bigger rewards > loss you are risking”. This is generally known as a “risk to reward ratio”.

The risk to reward ratio is the formula used to compare the unexpected returns of an investment against the risk of your loss.

You can determine and set your risk using a stop-loss order. Your chance is the price difference between the entry point of a trade and the stop loss order. On the other hand, you use the profit target to establish an exit point if the trade moves in your favor.

The profit of the trade is based on the price difference between the profit target and entry price. Investors use the risk-reward ratio to decide the worth of a trade or investment.

If you risk losing the same quantity of pips you desire to gain, then your reward/risk ratio would be 1-to-1 (written as 1:1).

For example: If you prefer to target a profit of 100 pips with a risk of 50 pips, then it would be 2-to-1 (written as 2:1). If you follow this simple rule, then you can make extra profits on your winning trades than your losing trades, but always making sure your rewards are greater than your risk.

Set Minimum Risk Rewards

The most normally recommended ratio to use is the minimum 1:1 ratio. This way you can at least break even if you are only right on half of your trades.

If you choose lower probability trading, a greater reward/risk ratio of 2:1, 3:1, or even 4:1 is recommended to ensure you make profits.

The information from the FXCM study suggests that 53% of traders who operated with at least 1:1 reward/risk ratio made a nice return over a 12 month period, compared to simply 17% of those traders who did not.

Data suggests that 53% of traders who operated with at least 1:1 reward/risk ratio made a positive return.