Risk : reward and time frame

Beginner Questions
1

Hello all! I’m back from a productive rest from the markets, having been overtaken by other obligations. Its amazing what a one month furlough can do to open your brains and make you see and understand things more clearly.

A few months ago, on my quest to find the best strategy for me, I started heavily thinking about risk/reward. I’m sure many of you have come across the frequent maxim of “Beginning traders should pursue 1:2 risk reward strategies, if not greater.” I did the math and yes indeed, the cool thing about 1:2 risk reward is that you can be wrong more often than right and still wind up ahead. Even cooler is 1:3, you walk away with money even if you’re wrong 70% of the time.

I started experimenting with 1:2 in an intraday timeframe, and found myself frequently very frustrated. The market, in the end, does whatever it wants to, and just because you want a 1:2 or 1:3 risk reward ratio doesn’t mean the market is interested in offering that at the moment.

Taking a step back, I noticed that on average, even when I practiced judicious stop trailing, I ended up getting on average a 1:1 risk reward. It seems I was good enough on direction in many cases.

In my general research, it seems to me that many short term intraday traders shoot for 1:1 risk reward, and enough of them trade with 2:1 and in some cases 3:1 risk reward, and walk away ahead (I remember Don Miller saying that at Trader’s Expo, “Some people say you should never risk 3 points to make 1, but I do it all the time and come out ahead.”) This initially shocked me, because I said to myself that if you trade with such a crappy risk reward, a string of losers can take you out fast. The biggest issue here was the fear of “being wrong”. I figured as a beginning trader, the odds are you’re going to be wrong on direction more often than not, hence you should pick a risk reward that lets you be wrong more.

However, with a 1:2 risk reward there is no more guarantee, in my way of thinking, that you’re going to come out ahead than with a 1:1. Furthermore, with a 1:2 we have to take into consideration that commissions skew the R:R less favorably to begin with. For example, if your goal is to make 20 pips, and you’re going to risk 10, with a spread of 3 pips you really are risking 7 to make 20 (or 10 to make 17), so your net risk reward is 1:1.7, not 1:2. Trading in the NY-London overlap, a 10 pip stop loss is just suicidal - at least in my experience. Expanding that to a 20 pip risk to make 40, the market may not be in the mood to give you 40 clean pips on many days (oh sure, it def. moves more than that, but good luck catching it!).

It seems that what my conclusions are leading me to believe is that an intraday trader is bound to stick with 1:1 or greater risk to reward ratios, in order to account for intraday volatility. The key here is to be right more often than wrong. Swing traders, by contrast, may find it easier to locate 1:2 and 1:3 setups.

In the end, what I am starting to believe is that there are several optimal parameters for a trading strategy:

  1. It offers a maximal amount of opportunities within any given length of time.
  2. It offers a high degree of accuracy.
  3. It offers a favorable risk to reward ratio.
  4. It is robust and not curve fitted.

It seems that these conditions are like the famous statement “Good, fast, and cheap: you can have two, but never all three”.

Your thoughts?

2 Likes
2

Yep thats one of the formulas for success. High win/loss that eats up your losers, even if the losers are bigger than the average winner.

Once you have money managment in place there are really only three forumlas that make money.

  1. High win/loss, as above.
  2. High reward/risk ratio, like you have found out there is no way to impose that on the market. Just because you risk 20 theres no guaratee that it will always hit 40 on winners. But, I guess some traders have methods that do this. The ones I’ve looked at don’t enter very often, only when certain patterns appear like head and shoulders.
  3. The holy grail, a high combination of both.

Myself, when trading on 1H EU. I have a hard catostrophic stop of 50 pips. I’m usually right about direction. But, I will get out if it appears to be reversing. Almost all my winning trades hit 30 pip, but I try to get in the morning in the overall direction and just manually trail my stop where it seems good.

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3

Good thread, and a highly misunderstood subject.

Static mathematics will make you a consistent loser.
Giving a trade hard lined parameters based on nothing more than a 1:2 (or whatever) ratio will get you stopped out for a loss far more often than not.

The market doesn’t work that way.

2 Likes
4

Yeah, like I said market furloughs are great - brains get a good cleaning :slight_smile:

Just for the heck of it, I calculated the required accuracy of negative risk to reward trading strategies if you want to breakeven, exclusive of the effect of commissions.

NEGATIVE RISK REWARD

3:1 risk reward

75% success rate to breakeven.

2:1 risk reward

66% success rate to breakeven.

1.5:1 risk reward

56% success rate to breakeven.

I guess if you have something that gives you a very high accuracy and offers enough entries, it can work out quite well.

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5

Below is a more thorough mathematical examination of strategies that require higher risk to reward, with commissions calculated in. For example, if you had a 3:1 risk reward, without commissions you would need to be accurate more than 75% of the time. Counting for commissions, if you were aiming to hit 10 pips (risking 30), you would need to be right MORE than 88% of the time in order to see any profit over the long term if the pair you were trading had a 5 pip spread.

As you can see, even with 1:1, you have a slight negative risk to reward ratio which becomes much less significant as the pip targets increase.

Raw risk to reward ratio 3:1
Theoretical accuracy to breakeven: 75%

Real accuracy required to breakeven with the following targets and commissions:
10 pip target, 3 pip com 82.5%
10 pip target, 5 pip com 88%
20 pip target, 3 pip com 80%
20 pip target, 5 pip com 81%
30 pip targets omitted

Raw risk to reward ratio 2:1
Theoretical accuracy to breakeven: 66%

Real accuracy required to breakeven with the following targets and commissions:
10 pip target, 3 pip com 76%
10 pip target, 5 pip com 83%
20 pip target, 3 pip com 72%
20 pip target, 5 pip com 75%
30 pip target, 3 pip com 70%
30 pip target, 5 pip com 72%

Raw risk to reward ratio 1.5:1
Theoretical accuracy to breakeven 60%

Real accuracy required to breakeven with the following targets and commissions:
10 pip target, 3 pip com 72%
10 pip target, 5 pip com 80%
20 pip target, 3 pip com 69%
20 pip target, 5 pip com 72%
30 pip target, 3 pip com 64%
30 pip target, 5 pip com 66%

Raw risk to reward ratio 1:1
Theoretical accuracy to breakeven 50%

Real accuracy required to breakeven with the following targets and commissions:
10 pip target, 3 pip com 65%
10 pip target, 5 pip com 75%
20 pip target, 3 pip com 58%
20 pip target, 5 pip com 63%
30 pip target, 3 pip com 55%
30 pip target, 5 pip com 58%

1 Like
6

One can do all the math in the world as it regards to probabilities in r/r scenarios. At the end of the day, if they can’t identify the correct time to enter, or exit a trade, they will still wind up on the losing end of most of them.

Although using smaller t/p points is a bit more effective, it puts you into more trades increasing both your risk, and trade costs.

True story. I had a demo a while back, and I was refining a trade strategy.
I had a 97% win ratio after 170+ trades, and still blew the account.

Funny how that works innit?

:smiley:

1 Like
7

What do you mean funny? Funny how?

Okay, I had to throw in the goodfellas reference :wink:

I guess its just important to know if you’re going to go for a bigger risk than reward, you better have proof that your strategy is going to score more often than not. That is very important if you’re going to have faith in it and execute it flawlessly.

1 Like
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Funny like I’m a comedian?:stuck_out_tongue:

See, the thing about it, is this. If you are setting your stops up correctly, your risk varies. Sometimes you might only have an 8 pip risk to get 100, sometimes it might take a 50 pip risk. The market moves differently every day. So, every day your risk will be different.

Looking at a chart long enough to understand what it is doing, will eventually tell you where to put your stops. Once you see it, nothing else will make more sense.

Static ratios mean nothing more than wasted pips.

1 Like
9

Yes, its a very tough thing to figure out without the experience. Right now I’m just working with 1:1 pretty much, then I’ll see over time where my entries could have been better and exits. I think thats the best approach for the time being. With Forex I notice that certain pairs in particular (the Sterling for instance) just love to create false breakouts. That forces more liberal stop losses.

1 Like
10

I can not enough agree to Mr. Tangs opinion!

Misses Market (most call it Mr, but I think she is more like a women) is doing what she is doing, no matter what rrr you plan to have or whatever “smart” theory you outline. Be flexible (That doesn’t mean unprecise or not disciplined). Love her (not in a way too much), adapt to her and then you may get what you want.

Regarding timeframes, I just like to add: It is also a matter of session and volatility. In asian sessions you may want to trade on M5 where in the high volatility sessions you may want to trade like the same in the H4 timeframe. The more volatility there is, the higher the noise in the lower timeframes. The lower the volatility is, the better you trade at lower timeframes.

Haven’t read that anywhere before, so it’s probably coming out of my (successful) experience. :wink:

1 Like
11

This thread is all i ever needed to confirm my findings, (10 years later, it is by far the most relevant, you guys are probably ahead in the game right now, if you figured out all these when i was still only 13y/o, big ups!)

Most people stick to “Static mathematics” to trade a highly dynamic and forever changing market, hence to date the number of successful traders is less, because most popular information out there is practically irrelevant, but common, which in turn means most people have access to this irrelevant information (by irrelevant, I mean highly impractical), which is why most traders are suffering devastating losses, you can never ever use a static RRR ever, that’s if you want to be a successful trader, everything has to be Dynamic, Dynamic Lot size, Dynamic Loss margin, Dynamic SL, Dynamic TP, risk will forever need to change in relation to the market movements and your forecast, You need to be able to forecast the main direction as well as the market pullback from which at most you SL will be based up on…

Regards,
Mr. Executives

1 Like
12

Try not to rely completely on mathematical analysis. It is important to identify entry and exit points as well. So be careful and look at different strategies.

13

Hey, you can consider trying different strategies. It is better to look beyond mathematical analysis and focus on strategy. Check the entry and exit points if necessary.