Forex Mistake #52 – Later Is Better or How Taking Profits Too Early Might Get You Broke

Why Taking Profits Too Early Might Get You Broke

If I were supposed to meet a friend at 8 o’clock and he would arrive 15 minutes late, I’d say “Mate, thanks for making me wait… but I guess it’s better late than never”. However, when it comes to Forex you’d be amazed to find out how many things are the opposite of everyday life. In Forex, “early” doesn’t necessarily mean better and later is sometimes the desired state. But let’s not complicate things too soon and let’s start explaining.

 

How Taking Profits Too Early Might Get You Broke

As I said, when it comes to Forex, early doesn’t always mean better. For example if you are trading retracements in a trend and you enter too early, you might get caught in a reversal (you think you are dealing with a pullback but actually the trend reverses). If you had waited a bit longer, maybe you would have seen some signs of trend reversal but your early entry worked against you. Ok that’s one way of going wrong with “early” but another one is taking profits too early. Yea, you might think: Dude how can I go broke if I take my profits off the table, and I limit my exposure to the market? Well, I agree with that way of thinking… sort of. But let’s think about this: taking an early profit means taking a small profit (unless the market is in a strong run) and this often means that your Take Profit is smaller than your Stop Loss. This brings us to the popular Risk – Reward discussion: if your Risk (Stop Loss) is higher than your Reward (Take Profit) then obviously when you hit Stop Loss you will lose more than you would have won at Take Profit. Let me use a simple example: 1 pip is 1 dollar and you have a 10 pip Take Profit with a 20 pip Stop Loss. On this trade you can either make 10 bucks or lose 20 bucks. If out of 10 trades you win 5 and lose 5, your bottom line is red because you’ve made 50 bucks (5 trades x 10 pips each at 1 dollar/pip) and lost 100 (5 trades x 20 pips each at 1 dollar/pip). This is what we call a 2:1 Risk to Reward ratio (your risk is twice as big as the potential reward) and can make you lose money although your win percentage is 50% (not very bad). Also, it’s the perfect example why taking profits early can get you broke. It’s like rowing upstream: you have to row twice as hard because the river is working against you. Now let’s look at the same example but let’s switch the ratios, using a 1:2 Risk to Reward. So, out of 10 trades we still win 5 and lose 5 but this time we make 20 bucks when we win and a losing trade will set us back 10 bucks: the winners will bring us 100 dollars (5 x 20) and the losers will total 50 bucks (5 x 10). See? Same percentage of winners vs. losers but we end up with money in our pockets just because we didn’t settle for an early exit.

 

How to Avoid Going Broke By Taking Early Profits

The answer is pretty straightforward: don’t take early profits. In other words, make sure you maintain at least a 1:1 Risk to Reward ratio. As George Soros mentioned, “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”. If the mindset of a prolific winner is the one above, why shouldn’t you and I adopt it? Plan your trading in a way that winning trades will make you much more than the bad trades set you back. Out of 10 trades, if you lose 1 buck 8 times and make 10 bucks 2 times… well, you don’t need me to tell you that you’ll make money…

Often when you see your trade in profit you think that it’s better to just close it, take whatever profit there is and walk away. It’s not the right mindset in my opinion because you will come to trade tomorrow and when you do you will use your regular Stop Loss and over time your average Risk to Reward ratio will tilt even more towards the Risk side. Its one thing to start with a bad ratio of, say 2:1 but it’s even worse to cut the winner short and take an early profit: if Risk is 20 pips and Reward is 10 pips but you close the trade early in profit, taking only 5 pips, your RR dropped to 4:1. Over time that will translate into… yup, you’ve guessed it: a broke trader

 

The Lesson to Be Learned

Forex is not about winning every trade so don’t be alarmed if you have a bad day or week. If you stick to your plan (yea, assuming you have a solid plan), you will eventually come up on top. If your winners are bigger than your losers, you can make money even if you are wrong more often than you are right. You don’t have to be a legendary accurate trader, you just have to be consistent and of course, to let your winners run, without taking early profits.

 

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