Risk-Reward Ratio in Trading

Risk-Reward Ratio in Trading

It is very easy to find hundreds of articles about risk/reward ratio in trading, but the problem is that most of those articles are not written by real traders who trade for a living or have been working as professional traders for a while. Most of them are written by freelance writers who are paid to write articles or bloggers and webmasters who want to drive some traffic to their weblogs and websites.

Most of these writers have never placed any order on the market throughout their lives. The bigger problem is that novice traders believe each and every word of these articles, just because they are published on the internet, but they don’t know that the directions that these articles give are not applicable in live trading. After reading these articles, novice traders try to apply them in their trades and after such a long time of trial and error, they will think that they are not able to follow the trading rules and so they give up, whereas it is the information and directions of the articles that can not be applied in live trading.

For example, on most of the articles you read about risk/reward ratio, it is strongly recommended that novice traders should not even think about taking positions with a risk/ratio of as high as 1:1 or even 1:2 (I will explain what these numbers mean later in this article) and the maximum risk/reward ratio of the positions that new traders take should be 1:3. There is nothing wrong with it so far, but the problem is that these articles never clarify if traders should have a low risk/reward ratio through having wide targets OR tight stop losses. As nobody likes to lose, specially new traders, they all think that they should make their stop loss as tight as possible to have a low risk/reward ratio trade, whereas this is a big mistake. No matter how tight or wide the targets are, a trader can not fool around with the stop loss. Choosing the stop loss has its own rules that can not be ignored or broken. If you set your stop loss tighter than what it has to be, you will be stopped out easily even when your position is correct.

Something that looks even stranger in these articles is that they emphasize that “novice” traders should not take positions with 1:1 or 1:2 risk/reward ratios. Does it mean that experienced traders can do it? Are there different trading rules and techniques for novice and experienced traders? Maximizing the profit and having 1:3 or 1:5 trades can be done by professional and experienced traders, but there are some technical and emotional difficulties in front of novice traders to do that. For example, to achieve a successful 1:5 trade, you may have several losing trades (I will tell you why). This is not a problem for professional traders at all, but for a novice trader who is learning the techniques and has to build his/her confidence at the same time, having losing trades can cause lack of confidence and excessive fear that prevent him/her from advancing to the next steps.

So we can not believe and apply whatever we read over the internet. There are zillions of systems, techniques, indicators, robots and… that are absolutely useless when it comes to live and real trading.

After the above introduction, lets see what risk/reward ratio is and why it is important in forex trading. Risk is the amount of the money that you may lose in a trade. If you have already read the money management article, you know that we should not risk more than 2-3% of our capital in each trade. It means when we find a trade setup and we find a proper place for the stop loss, we have to choose our position lot size in the way that if the market hits our stop loss, we lose maximum 2-3% of our capital. For example we have found a trade setup with EUR-USD that has to have an 80 pips stop loss. We have a $5000 account. If EUR-USD hits our stop loss, we should lose $150 which is 3% of our capital (0.03 x $5000 = $150). It means 80 pips equals $150 (you can use the position size calculator I have on the money management article). This $150 is our risk. But what is the reward? Reward is the profit that we can make in a trade. In the above example, if we choose a 160 pips target for our trade and EUR-USD hits this target, we will make $300 (when 80 pips equals $150, so 160 pips equals $300). This $300 profit is the reward.

So what is the risk/reward ratio of this trade? 150:300 = 1:2

The larger the profit (target) against the loss (stop loss), the smaller the risk/reward ratio which means your risk is smaller than your reward. For example if your stop loss is 20 pips in a trade and your target is 100 pips, your risk/reward ratio will be 1:5 in this trade.

What is the recommended risk/reward ratio in  trading?

1:3 or 1:5 risk/reward ratio is achievable when the market forms a trend and you succeed to enter on time. In most cases you should be able to hit the top and bottom of the trends, no matter on what time frame you trade. Or if you enter at the middle of the way, the trend should be strong enough to give you another big movement and make a profit which is 3 or 5 times bigger than your stop loss. You can do that. Why not? But there are just a few problems: 1. Markets form a trend in less than 30% of the cases; 2. Some trends are not strong enough that if you enter with delay and while they are at the middle of the way, they can hit your target which is 3 or 5 times bigger than your stop loss. 3. There are many cases that you miss the trends; you hesitate to enter and so you miss the chance; you think you have found a trend whereas you are wrong and it returns and hits your stop loss and… . So you lose in many trades, because you want to catch a big one.

So in reality, you have to lose in many trades, or have many of your trades closed at breakeven by the stop loss (because you will have to move the stop loss to breakeven when you are in a special amount of profit), or not to trade for such a long time waiting for a strong trend, until you can have a 1:3 or 1:5 trade.

How is it possible to catch a 1:3 or 1:5 trade without losing so many other trades?

If you take a position with 1:3 or 1:5 stop loss to target ratio and then you wait for it to hit your stop loss or target, you will have so many losing trades before having a winning trade. The reasons are mentioned above.

The solution is in moving the stop loss. You should not let your stop loss remain at its initial position. To have a 1:3 trade, the distance of your entry and your final target should be splitted into 3 parts (at least), while each part is equal to your original stop loss value. For example if you have a 50 pips stop loss, you should have a final target for 150 pips which should be splitted into three 50 pips levels. Then you should move your stop loss in three stages (in this example I assume that you take a 3% risk in each trade):

1. If the price reaches to the first 1/3 level, you should move the stop loss to breakeven. At this stage, if the price goes against you and hits the stop loss, you will get out without any profit/loss, BUT you should consider that you had an initial risk of 3%.

2. If it reaches the 2/3 level, you should move the stop loss to 1/3 level. At this stage, if the price goes against you and hits the stop loss, you will get out with a profit which equals your initial risk. For example if your stop loss has been 3% of your account, you will get out with a 3% profit. Therefore, such a trade will be ended as a 1:1 risk/reward trade.

3. If it becomes so close to the final target, you should move the stop loss to 2/3 level. Then you have to wait until it hits the final target or returns and hits the stop loss. At this stage, if it goes against you and hits the stop loss, you will get out with a profit which is twice of your initial risk. For example if your stop loss is 3% of your account, you will get out with a 6% profit. Therefore, such a trade will be ended as a 1:2 risk/reward trade. If the price hits the final target, your trade will be closed with a 9% profit and so you will have a 1:3 risk/reward trade.

So, to have a 1:3 trade, you will have some -3% trades which are those trades that hit the stop loss at its initial position. You will also have some 0% trades that are those trades that hit the stop loss at breakeven. Some of your trades will be +3% trades which are those that hit the stop loss at 1/3 level. Some will be +6% trades which are those that hit the stop loss at 2/3 level. And finally, some trades will be +9% trades which are those that trigger the final target.

Now the question is what percent of your trades will be -3%, 0%, +3%, +6% and 9% trades?

It is impossible to answer the above question, because it depends on many things including the trading strategy and market condition. However, there is something that gives us a clue about the number of our 1:3 and 1:5 trades. It is the fact that says market trends only in 30% of the cases and it makes ranging, 70% of the time. To have 1:3 and 1:5 trades, we should have a strong trend, otherwise our stop loss will be triggered in one of the stages before reaching the final target, no matter what time frame you use to take your position.

No need to remind again that in any of the -3%, 0%, +3%, +6% and 9% trades your risk is the same which is 3%. The first conclusion is that taking the risk and the position is up to you, BUT it is the market that determines how your trade should be ended. This is something that all traders, specially novice ones should consider. When you read in different websites and web pages that your trades should only be 1:3 and 1:5 trades, you should consider that you really never know how many of your trades will be ended as 1:3 and 1:5 trades.

The stop loss of the positions that I take are chosen based on the technical analysis rules that I have for myself. I will never break any of these rules. Some traders think that my stop losses are too wide, but they are not. Unlike some other traders who have a constant value for their stop loss (for example any position they take, with any currency pair and any time frame, has a 120 pips stop loss), I mainly follow the rule of thumb we have for setting the stop loss. The rule says that you should place your stop loss in a position that becomes triggered only when the direction you choose is completely wrong. So when I want to set the stop loss, I ask myself under what condition the position I have taken is wrong. The answer I give to this question is the position of the stop loss. In one of the articles I published long time ago, I have explained about setting the stop loss and target orders.

So my stop losses can not be tighter. What about the targets? Can they be wider?

In the way that I choose the entries, most of our trades can have bigger targets and having 1:2 and 1:3 trades is possible with most of the positions we take, because our entry point is always well-chosen. Of course it can be different in different days, weeks and months. I will tell you how to trade my signals in the way that you can have 1:3 trades.

Now the question is if my signals can be used to have 1:3 and even 1:5 positions, why my targets are smaller than what they can be?

As you know in the typical signals that I send the members, usually there are two targets. The first target is usually half of the stop loss size and the second target is the same size as the stop loss. Traders can close 50% of their positions at the first target and then move the stop loss to breakeven. Then they can close the second 50% at the second target. There is a second way too. They can just move the stop loss to breakeven when the price reaches the first target and then close the whole position at the second target. In the last performance report I have published, I have explained 4 different ways that members can trade the signals I send them.

To answer the above question that why my targets are small, I have to say that they are small because there are different traders with different levels of skill among the members. Advanced traders know how to maximize their positions. They just use my signals to enter. However there are many other members who like to take as many positions as they can and they like to see them finished all green and positive. As I said above, they are building their confidence while they are learning the techniques. They need to see the positive result of the things they are learning. They are not disciplined and patient enough yet to maximize their trades and it is so painful to them, if a position which is in a good profit, suddenly goes against them and hits the stop loss at breakeven and they get out without any profit. The tight targets I have in the signals I send the members, are for these members. Unlike the others who believe novice traders should start with 1:3 and 1:5 trades, I believe they should start with 1:1 and even bigger risk/reward ratios to build their confidence. When they become more skilled, which can take them a few years at least, they can maximize their profits and have 1:3 and 1:5 positions. I am 100% sure that those who say novice traders should only take 1:3 and 1:5 positions, are not real traders and know nothing about live and even demo trading. Unfortunately there are zillions of them these days who develop  websites, weblogs and even robots and e-books. Forex is just a market for them to make money, not through  trading, but through selling useless  related products to “novice” traders.

Anyway!

From now on, each signal comes with two sets of targets. In the first set, the targets will be the same as they were used to be in the signals I sent. In the second set, the targets will be for a 1:3 risk/reward trade. The stop loss will be the same in both sets, because as I said I can not make the stop losses tighter. It is up to the members to choose the way they like to trade. We will have enough instructions in members area to help members to take their positions with any level of risk/reward ratio they like.