“Risk reward ratio” is a phrase you will hear often in trading circles.
Many traders pay lip service to risk reward and money management while actually expending their time and energy looking for the “holy grail” trading system which just does not exit.
This article focuses on “risk reward” which is the mathematical ratio utilised by many traders; risk reward enables traders to calculate the anticipated return on an investment in comparison with the exposure to risk. The figure is arrived at by dividing the amount of pips the trader anticipates making by the amount they can potentially lose.
• Entry Price
• Stop Loss Level
• Profit Target
• The resulting Risk/Reward Ratio can be calculated by the above
Clearly define risk
All trades we enter are at best the execution of an edge. Trading is a game of probabilities; in this respect there are numerous external elements that could “flip” the market’s direction in seconds and cause a loss. Event risk can turn the market on its head so the trader must place a protective stop loss when entering a trade.
The following rule contains, what is possibly, the most important process that aspiring traders should adhere to:
Prior to going into any trade, you should acknowledge your exit level, that will be triggered, if the trade goes against you.
Here lies the most effective way of ensuring your losing trades are contained and you don’t “blow the trading account” when the inevitable losses eventually come. This simple rule is often ignored and a lack of discipline, in this area, is probably behind the majority of blown accounts and not the trading system itself.
Fixed percentage allocation
Further to this, good money management dictates that a fixed percentage (or similar amount) of the account is assigned to a trade regardless of the stop loss size in pips. The stop loss should never be assigned according to the monetary value of a potential loss; the technical/fundamental exit criteria should determine the exit point and the appropriate leverage is then assigned.
Always allocate risk before entering the trade
Risk should be planned before entering the trade. The most obvious, and logical, time to plan this is before entering the trade – without the pressure and adrenalin associated with risking your hard earned money. The temptation may be to enter a trade with an approximated position size during fast moving markets as the fear of missed opportunity takes hold – this is unadvisable as ambiguity in this area is a dangerous thing.
Initial stop loss placement
The initial stop loss should be placed in accordance with the system rules; this stop loss could be placed in any of the following ways or more:
Hidden behind price structure (swing lows and highs)
A Fibonacci percentage stop loss.
Test the exits
Different exits (reward strategies) should be tested beforehand in order to ascertain the optimal exit strategy for your trading style. Some traders prefer a fixed reward and others need to let the profits run. Anyone choosing a fixed reward method needs to appreciate they will never catch a home run; likewise, any trader choosing a “let it run” method will see many small winners turn into break even at best.
A decision also needs to be made as to when the exit strategy kicks in. Choices include the following:
- As soon as the trade is opened
- After a set period of time
- After a fixed percentage of profit or loss is seen i.e. stop to break even at 1:1 risk reward ratio
This post cover exits in more detail. See Forex exit strategies.
Further thoughts on “reward”
The potential reward that can be gained from a single trade is unlimited. This is an extremely simple but powerful concept that should be carefully considered by any aspiring trader. One popular exit method is to minimise risk as soon as possible and let the market “give what it will”. This approach defines risk but removes the need to even think about reward.
Forex currency pairs can move in one direction for years as economic trends develop and money flows from one country to another. The ideal trading system will allow the trader to capture large moves and one of these winners could potentially cover a large run of losses and still provide additional profits. However, a mathematically optimised method does not always provide the most user friendly system. Traders, as human beings, need to find a method that fits their personality and therefore minimises the potential for diverging from the rules that have been set.
Feel good factor
Many traders prefer a high win ratio and smaller resulting profits – as this feels good when the winners roll in! However, care should be taken in not allowing the risk reward ratio to reach a stage where a few losses is equal to, or greater than, a year’s worth of winning trades. I see traders taking profits at 1:3 risk reward and stating that their win rate is “high enough to carry the losses”. In this scenario, four losses in a row is equal to twelve winners and is a distinct possibility in any market environment – never mind the current market conditions where whipsaw price action, based around sovereign debt news, is a common occurrence.
What works for you?
Take some time to think about your current strategy and how a series of losses could affect your bottom line. Should you be allowing your winners to run, specifying a minimum profit target or moving the stop loss to break even? Maybe you have no problem letting winners run but ignore significant support and resistance to the detriment of your account. Look at what is best for you and make any necessary changes.