Many say use a risk to reward ratio of 2:1. I understand this, but I do not understand how you can consistently abide by this.
Say you have $10,000 capital in your trading account. Using a rule such as the 1% rule, we can risk $100 per trade. This means we will aim to risk no more than $100, whilst aiming for a profit target of $200 or better.
Does this mean that every trade you place must be with the same $100 stop loss and $200+ take profit with every trade? (I know this will change as your account grows/diminishes). Using a 2:1 ratio would mean we can afford to lose twice as many trades than we win in order to breakeven. But this only applies when all your TP and SP levels are set the same as all previous trades. How can you manage risk if you use a smaller position such as $100 TP and 50$ SL or $10 TP and 5$ SL? Or a larger one like $500 TP and $250 SL. One bad trade with a different TP/SL size would ruin the supposed 2:1 ratio of being able to e.g win 100 trades and lose 100 trades and still come out with profit.
I’m sure I have over complicated this but if anyone understands what I’m asking and can answer please do. I haven’t finished the school course so if it is answered there I apologize.
First of all, welcome to Babypips. I will try to answer your question to the best of my ability, more experienced traders I am sure will chime in and offer their advice too.
The 1:2 risk:reward ratio (RR) is a general guideline as to how to use good money management skills. It shows in a statistical way, if all things remained equal in a controlled environment (meaning if you loose a trade, you loose everything you risked and if you won, you won exactly twice the amount you risked) how you can win 100 trades and loose 100 trades with a 1:2 RR and still come out ahead. However, that is simply an example to show you how a 1:2 RR statistical edge works. In the real trading environment, things are very dynamic and nothing is constant. 1:2 RR is a [B][I]reference point[/I][/B] when examining a chart and determining if it is worth the risk of opening a trade.
Once a trade is opened, it literally can go anywhere. You may end up with 1:-1 or 1:10, however, 1:2 RR is a good rule of thumb to [B][I]gauge [/I][/B]an entry. If you have a strategy that allows you a clear picture of of entry and exits, then by all means, plan for a bigger reward if there exists one. The key word here is strategy. R:R will only work when a trader [B][I]HAS[/I][/B] a solid strategy that has an edge, meaning that statistics and probability will lean in the favour of his or her strategy over a given period of time.
As far as your question about sizes of trades affecting the 1:2 RR, yes, you are right, if a trader changes the amounts of R:R from one trade to the next, and if they have no idea of what they are doing, they will burn their account regardless of what statistical probabilities are at work. Haphazard changing of amounts from one trade to the next indicates emotional trading which is essentially gambling.
The general logical progression for a trader is to start small and steadily work their way up from there. When you have a solid strategy, a sound mind and some experience, then when you apply 1:2 RR, it will be profitable in the long run.
I hope I have helped answer your questions. Welcome again, thanks for posting and best of luck in your journey!
What this means (if you were looking to stick to the 2:1 rule)…
Say you have an entry at “0.9500”, where is your stop loss? (I place mine below a recent swing low going long, or above a recent swing high going short).
For example, my stop loss is placed at 0.9400. This is my risk; 0.9500 - 0.9400 = 0.01
Now the market and recent price tells me where my obvious target profit is, going long, where is the resistance? previous day’s high, major swing high, support/resistance etc… This target profit has to be above 0.9700 (2:1 risk), if it is not, you don’t enter the trade.
Sticking to “2:1” as a rule, means don’t take trades that don’t offer 2:1 R:R. It doesn’t mean risking $10 to make $20, the market and price tells you where you’re likely to find support (and resistance).
Thanks guys for the replies, but just to clarify. If one’s system uses a strict Risk:Reward ratio of 1:2, does that mean each trade must risk the same amount of pips each time. (JN’s example of 100pip:200pip). So I would only enter the trade if key levels on the chart allowed for a logic setup of 100pip stop loss and 200pip take profit each and every time? And does that mean each trade has to have the same volume (for example 10,000 base units). Or can the next trade you take for example be 50pip stop loss and 100pip take profit at key levels but you trade with 20,000 base units to keep the money earnt/lost constant throughout each trade.
I’m sorry this just is not clicking, sorry for the questions!
In answer to your question (I think I missed it), a 2:1 trade is 2 units of reward for 1 unit of risk.
So “any” number of pips works, as long as the reward is twice as much as the risk. You adjust the contract size to suit the number of pips risk and the dollars you are willing to lose.
Ah thanks, that cleared it up for me. So basically, pip size is irrelevant, so long as it meets our preferred risk to reward ratio, but the thing we change is the volume of base units that will be traded. And thanks for that calculator, it’s very useful!
Now I can hopefully fully implement a nice strict risk to reward ratio for my trades seeing as now I kinda know what to do now.
No probs. Once you’ve got a consistent system, or are happy with your trade entries, you can start to target less R;R trades, 1:1 etc… but until you’re confident in your entries/statistical edge, it’s best to stay away from anything less than 2:1.
On a smaller timeframe, don’t forget to include spread and slippage in your entry and SL, as it’ll effect your position size.
The best thing about really getting to grips with risk management and position sizing, is you realize a 12 pip winning trade with a 3 pip risk is the same $$ profit as a 100 pip profit risking 25 pips
2:1 is a good rule of thumb as it allows you to be wrong more than being right,but there are loads of different ways to trade, you just have to find the way that works best for you.
Personally I don’t even move my SL to BE before 2:1 risk to reward is reached and don’t take trades unless they have at least a 10:1 RR ratio.
Yup, you should look at risk reward ratio using R-multiples instead of number of pips. Based on your trading system, your stop loss for this particular trade setup is 15 pips and your take profit is 30 pips. For another trade, your stop loss based on your trading system might be 35 pips and take profit is 70pips. You just need to determine how much money you are willing to risk per trade and you can then calculate your position sizing based on this and your stop loss. No matter how big the stop loss is, you can always adjust your position size to make sure you are always risking the same dollar amount per trade.
Thanks for the replies guys. Another question about exiting. I regularly win on swing high or swing lows in direction of the trend (Demo account), but often miss out on larger movements (like may gain 100 pips, but the total movement was 200-300+). How can I use advanced take profit to abide by my rule of every trade will gain 2% or MORE, while still being in the market to capture the larger movement? IF you sell lets say half of your position at your original target, you’ve made half of desired profit, and the other half can continue to follow the larger movement, but you will have only made guaranteed 1% and I’d like every trade to be at least 2% (basically 1:2 RR). I know it’s good to be conservative but when you are often missing out on larger movements I’d like to stay in the market for longer to capture the larger gains. Also when is a good time to move SL to break even?
A (Reward to risk ratio ) RRR should be an optimal target, and help you with your risk management and your trading plan. If you entered a trade with a limit and a stop at a ratio of 2:1 you would probably achieve target 1 in every 10 trades your RRR will average out maybe at 1.5:1. So if you wanted to achieve 2:1 reward to risk you may need to aim for 3:1. But also consider your win rate as the bigger your RRR the lower your win rate will be.
However the most profitable combination of reward to risk for a particular trading strategy may be for example a 30% win rate and a 4:1 RRR. However that is based on a Robot taking trades, when you factor in a human psychology you find that a win rate under 30% which means the probability of drawdown periods, losing days and weeks is higher. Then it will cause the trader to trade differently and not follow the trading plan/ strategy and thus the system does not work. So I believe that a win rate of over 50% is a necessity and my signal actually runs around 70% as humans like to win.
So that being said naturally the stop losses must be bigger and RRR (between 1:1 and 2:1) lower, but the trader is happier trading and more consistent.
Now this is based on trading strategies where trades are held for hours to days, for swing style trading the RRR can be higher.
Seems like you have your priorities right, ha ha, most traders look at the millions that they can make, basically manage your risk first, then the rest. To be successful you need 3 things,
More winners than losers
Be consistently profitable
RRR OF 1.1 OR higher
