Sunday, August 28, 2011

Reward-to-Risk Ratio

Reward-to-Risk Ratio
Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:

10 TradesLossWin
2 $3,000
4 $3,000
6 $3,000
8 $3,000
10 $3,000

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.

And this is a big one, like Jennifer Lopez's behind... setting large reward-to-risk ratio comes at a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios.

Let's say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio, this means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread.
If your broker offered a 2 pip spread on EUR/USD, you'll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate of EUR/USD could move 3 pips up and down within a few seconds, you would be stopped out faster than you can say "Uncle!"

If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips.

By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right?

In the real world, reward-to-risk ratios aren't set in stone. They must be adjusted depending on the time frame, market environment, and your entry/exit points. A position trade could have a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1.

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