Risk – Reward Ratio

Other ways you can increase your chances of profitability is to trade when you have the potential to do three times more than you risk. If you establish a risk-reward ratio of 3: 1 you have a significantly greater chance of ending up being profitable in the long term.

Check out this table as an example:

10 TransactionsLossesProfits
1$ 1,000
2$ 3,000
3$ 3,000
4$ 3,000
5$ 3,000
6$ 3,000
7$ 3,000
8$ 3,000
9$ 3,000
10$ 3,000
Total$ 5,000$ 15,000

In this example, you can see that even if you win only on 50% of the transactions, you would still make a profit of $ 10,000. Just remember that as long as you trade with a high risk-reward ratio, your chances of being profitable are much greater even if you have a low hit percentage.

BUT…

Risk - Reward Ratio

And this is very big, like Jennifer Lopez’s butt… setting high risk-reward ratios has a price. At first glance, the concept of establishing a high risk-reward ratio sounds good, but think about how to apply it in the current scenario.

Let’s say you are a hoarder and you only want to risk 3 pips. Using a risk reward ratio of 3: 1, this means that you should have 9 pips. At that point, the reality is that the odds are against you because you have to pay the spread.

If your broker offered a spread of 2 pips between EUR / USD, you will have to gain 11 pips, forcing you to take a difficult 4: 1 ratio. Considering the EUR / USD exchange rate it could move 3 pips up or down in a few seconds, so you would have to stop faster than “Dude” would say.

If you were to reduce the size of your position, then you could extend your stop to maintain the desired risk / reward ratio. Now, if you raised to 50, the amount of pips you wanted to risk, you would then need to gain 153 pips. By doing so, you can get much closer to your desired risk-reward ratio of 3: 1. It wouldn’t be so bad, right?

In the real world, risk-reward relationships are not set in stone. They should be adjusted depending on the time frame, your portfolio environment, and your entry and exit points. A position could have a risk/reward ratio as high as 10: 1 while a hoarder could go as high as 0.7: 1

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