Wednesday, 14 July 2010

10. Risk Reward Ratio

Much misunderstood is risk/reward, yet it can be your perfect ally.

You know by now just how unpredictable the market is, you have learnt that trying to predict what is going to happen next is more difficult than you thought. Your percentage of winning trades is much less than you had hoped for and you are barely making a profit. If you are not practising a good risk reward ratio then this brief article may help you turn a corner.

Just to be clear, a risk reward ratio (RRR) illustrates the relationship between the amount you are risking in your stop with the amount you expect to gain in profit at your target. So if you are aiming for a profit of 40 pips with a 40 pip stop behind your entry then the RRR is 1:1. I look for trades with a RRR of 1:2+ i.e. a profit target at least twice the size of my stop because with this level of RRR, you only need to win 33% of your trades to break even, anything above 33% is profit. Suddenly your % of wins doesn't look so hopeless does it?

Let's look at some numbers to illustrate this: -

Using a 25 pip stop and 50 pip target to give us a RRR of 1:2 over 12 trades.

Winning trades 4 (33%) x 50 pips = 200 pips profit

Losing trades 8 (66%) x 25 pips = 200 pips loss

Break even, simple.

Using a RRR of 1:1 or less (yikes!) means you are depending entirely on your trading edge to grow your account. There are plenty of trades with RRR 1:2+ every day, why take anything less?

To avoid reducing your overall RRR it is also best to avoid the temptation to close trades early, covering the last loser or getting spooked by a retrace are classic examples. If you get into the habit of interfering and exiting because of fear or greed you will be back to 1:1 and below in no time. The only way forward is to make it count over a large number of trades.

Trading multiple lots and taking partials also skews RRR, so if you regularly do this you must ensure that the trade has the appropriate potential.

For example: -

Our trade with a 25 pip stop x 2 lots must now have the potential to travel much further because :-

Risk @ 25 pips x 2 lots = 50

Taking 1 lot partial profit at +25 means the second lot needs to go to +75 to preserve 1:2 RRR.

These are of course simplified figures but hopefully the impact is clear.