Reward/Risk Ratio

Beginner Questions
1

I always hear about having a good reward to risk ratio like 2:1 or better, but I’ve noticed that this is usually not practical. Unless you happen to stumble across a nice trend, I haven’t seen it to be likely that a person can find frequent (once a day) trends that will allow a person to reap the benefits of a TP of +90 with a stop of -30 for a 3:1 ratio. I’ve noticed that most of the time I get stopped out before I get remotely close to the TP.

What do you think about this? Do you use a 2:1 or better ratio and what strategy do you use to obtain this? Do you find that you get stopped out most of the time resulting in a decline in your budget while attempting to obtain 2 or 3 times more pips than your stop?

2

Put your entries where your stops are…

3

I don’t know you, and I don’t know how you trade. So, everything I’m about to say is based on some assunptions about what you’re doing, and it’s likely to sound critical. Please don’t take it as personal criticism.

I’m going to describe some serious mistakes that I used to make. You may be making these same mistakes. In the trade that I’m about to describe, when I talk about the mistakes that “you” make, I’m talking about all of us — up to the point where we learn to stop making those mistakes.

Have you ever done this?

You study your charts, and find a situation that catches your eye. You really like the way things are shaping up for this pair. You conclude that this pair is poised to move higher, and you want to get on board.

You open a LONG position, and immediately set a stop-loss to protect yourself. Your stop-loss is 30 pips, because that’s about as much pain as you can stand.

You definitely want this trade to justify the risk you are taking, and you have heard the advice of the “experts” to use a R:R ratio of at least 1½:1, so you decide to set your TP at 2R — that is, 60 pips.

Now, you sit and wait. Price moves up and down, up and down, up and down, all the while trending higher toward your TP, and you’re feeling hopeful.

At about +30 pips, price stalls and begins to retrace a bit. You start to sweat, but you hang in there, because you’ve always heard, “Cut your losses, and let your profits run.” You don’t have a loss; you have a small profit. So — determined to let it run — you hang in there. And sweat.

There are lots of scenarios that could unfold from this point forward. Obviously, the desired scenario is this one: the retracement ends, price resumes its upward move, and your TP is hit. But, you’re telling us that it almost never works out this way for you.

So, let’s analyze this trade from a different perspective.

There are two horrendous mistakes in the way this trade was structured.

• The first involved the STOP-LOSS. Placing a SL at your pain-threshold is about the weakest thing you can do. Probable support levels should have dictated where you placed your SL. Support comes in many forms: previous daily, weekly, and monthly lows (or highs); pivot levels; fibonacci levels; and even trendlines (which are potential dynamic support or resistance levels).

If your chart suggests a logical place for your SL, and it’s more than you can tolerate, then either (1) cut your position size in order to make your risk in dollar-terms acceptable, or (2) this trade is just not for you — wait for a better one.

• The second horrendous mistake in the trade described above involved the TAKE-PROFIT. Placing a TP at a point that will make you a certain desired profit is as bad as placing a SL at your pain-threshold. But, that’s exactly what you did in the trade described above: you arbitrarily decreed that price should rise 60 pips, because 60 pips is how much you wanted to earn.

Probable resistance levels should have dictated where you placed your TP. Better yet, two or more probable resistance levels should have dictated two or more TP-points; in other words, if possible, you should have scaled out of your position in a way that covered your risk as quickly as possible, while still allowing the remaining portion of your position to run further into profit.

Suppose you do all this analysis, and determine that probable support and resistance levels are offering you a trade with only R:R = 1:1? If R:R = 1:1 is unacceptable to you, then this is a no-brainer — you don’t take this trade.

When you open a chart, you are viewing a battlefield. Before you wade into that battle, let the strategic and tactical situation on the battlefield (not your pain-threshold) define the risks. And let the strategic and tactical situation on the battlefield (not your greed, or your fixation on a R:R ratio) define reasonable potential profit objectives.

And that, pastor, is the end of my sermon.

1 Like
4

Hi, forexpastor. Just so you know, I’m not a professional trader, just another noob trader trying to learn, but I have been profitable over hundreds of paper trades, full disclosure.

I understand what you’re talking about, how everybody says you should have a reward:risk ratio of 2:1 are better, but that’s really misleading.

All that matters is expectation, which is the comparison of your reward:risk ratio to your success rate. If your trades average twice what you risk, when you win, you have to win more than 33% of the time to be profitable. If your trades average half what you risk, you need to win more than 66% of the time to be profitable. The reward:risk ratio in and of itself doesn’t tell you anything.

Don’t let your small wins turn into full risk losses just because you’ve heard you’re supposed to earn so much per trade. It’s probably impossible to be profitable that way. One strategy, advocated by the James16 group, has you cashing out half your position after even a small profit, then moving your stop to breakeven, and letting the rest ride. Once you get your stop to breakeven, you’re in a risk-free trade. I suggest you check out the front page of the James16 thread for alot of good trading advice. (Since this is my first post, I can’t post the link, but the thread is in the commercial forum at ForexFactory.)

An important related issue is risk of ruin. Everybody experiences variance, even with a great strategy. If you risk too much of your account per trade, variance can be devastating and push your risk of ruin close to 100%. I wouldn’t risk more than 3% per trade.

Good luck.

5

To the OP: I don’t think about risk / reward because I use mechanical strategies that adapt to market conditions. The most important thing is not to get hung up with the statistics of your past returns. They are past returns and unless you have an edge, they don’t have anything to do with future returns. Your focus should be on finding / developing an edge and only on trading that. An edge is a repeatable advantage you have over all the other market participants. Edges typically derive from repeated market phenomenon, like the fact that the daily/weekly open/close is at a given time and there is a tendency for new money to come in at that time which may be exploitable in some manner. Focus on finding an edge or developing one based on original research you perform on the market of your choice, and you will have an advantage that will allow you to profit in the future, not just in the past.

6

People learn from their mistakes, and so would you.
Everybody starts here with such things, you just need to keep on diversifying your portfolio. More diverse it is, more profitable would it be. :slight_smile:

-Charles

7

A(nother) quality post from Clint, so I won’t seek to overlap too much, but one point stands out to me, which is really an extension of what Clint said. I have never taken any heed of hearing that a certain R:R is optimum, almost as though it is an industry standard. My R:R varies per trade. For most of my trades, I will take any setup that gives me at least 1:1. Sometimes there is no room to more ambitious than that, as there are S/R levels or something in the way (per Clint’s post earlier in the thread), but that is fine - my strategy is right more than it is wrong, so 1:1 is fine. I sometimes get 5:1 trades, not because I am trading differently, but because the next ‘obstacle’ to my trade is that far away from my Entry, and the sensible place for my Stop is comparitively close. So I would strongly echo what Clint said, you are coming up with the answer before you know the question - let the setup tell you the R:R for any given trade, don’t listen to rumour and hearsay.

After all, if you have a strategy that genuinely gives you more than an 80% success rate, then an adverse R:R can be perfectly acceptable, as long as you know why you are doing that.

But basically, my advice would be just keep rereading Clint’s post until you understand in depth why it is right!

ST

8

Hello
The r/r ratio is NOT something that you can determinate before entering the trade. There are 3 things that you need to do to improve this ratio:

  1. First, you filter trades that have the best chances of a good r/r ratio (1:2 or above). So if you have a long trade with a SL of 30 pips and the next resistance point is at 20 pips frm the actual price, then you dont take the trade. You only take trades THAT HAVE A GOOD CHANCE OF MAKING A GOOD R/R RATIO. You dont determinate the r/R before, you need to evaluate the set up before and decide if it is worthy.

  2. Second, if you decided to take the trade then you need to exit at a maximum point of profit, because most of the time the price wont hit your TP. So you need to find a trailing stop method to maximize your profits and that way maximize your r/r ratio. The trailing stop method depends of your strategy and you need to DEMO TEST it and compare differente methods to find the best for your strategy.

  3. If you want to improve your r/r ratio you also have to try to find cheap entries, this means small stop losses. Of course you cant force the market because you will get stopped out. So you have to determinate the set ups that gives you cheaps entries because in the end those are the ones that will improve your r/r ratio.

The r/r ratio is not every trade, is a measure of all your trades. So in the end you will have trades with small r/r ratios, and trades with big r/r ratios, and the result is a good r/r ratio. You need to calculate your r/R ratio every week and every month, so you can see how you improve.

Hope that helps!

9

I just learned more about money management TP/SL in your post then most articles I read about money management.

10

Thank you, sir. I’m humbled by your comment.

11

As a pastor would say, “Amen to that.” Great post Clint, I printed it and it goes on top of my short reading list to review before I start trading in the mornings. Thanks.

12

Thanks, dobro. I don’t deserve such lavish praise. But, I appreciate it!

13

i remember there being a excel spreadsheet to calculate your R:R based on your % risk and deposit amount anyone have any idea where it is?