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| Risk to Reward |
A key aspect of money management is your risk to reward ratio. It essentially tells you how much risk you are willing to accept if the trade stops out vs. how much money you will make if the trades hit's your objective.
Now, this has a similar effect of the 2% rule, but instead of focusing on the downside, you are forced to have an objective. This is very hard for most traders, it is much easier to hope than draw line in the sand and say, "I will sell when it reaches that point." Whether you use a trailing stop, or a target, it doesn't matter. Every trader needs to have a system where they know when to take the profits off the table. The Purpose of knowing your risk to reward ratio is not so you can avoid risk. Avoiding risk is impossible! It is required so you can put yourself in a position where you can manage your risk. You should think of yourself as the CEO of your own bank, your job is not to predict the future, and decide what trades are going to work and what trades will fail, rather, your job is to understand what you are putting on the line and what your returns will be if things work out. This is the way of the smart little piggies.
The Calculation: potential profit / potential loss = reward ratio
Example: If you are looking at a trade and figure that your risk is $400 and your profit objective is $800 then: $800/$400 = 2 or ratio = 2:1 The ratio will always be figured as your reward first, with your risk always at 1. so if you had a ratio of 0.5:1 it would mean that you are risking $1 to make 50 cents, obviously that is not a good idea. That would mean that you would have to be right more twice as much as you are wrong, just to break even. The opposite is true for a 2:1, you actually have to be right less than half the time to break even. That's my kinda math! If you only took setups that provided a Risk to Reward ratio of 2:1 or greater you would give yourself a trading edge over most traders out there who have no such concept of risking less than their objectives.
Let's look at a chart:
Here we have the same example used in defining what our risk was going to be using the 2% rule. If you remember from the 2% rule example our entry was 531.00 and our stop loss was 529.00, giving us a 2 pt risk if the trade went against us. Now we need to decide on where a logical place to exit the trade if it does go our way would be. In this example we will set our target at 535.00 as that was the previous high, and we are expecting price to respect the upward trendline and retest those high's. Our profit target is 4 points.
Calculation: $4 target / $2 risk = 2 reward so this trade does have a 2:1 ratio. we are risking $1 to make $2.
Generally speaking the higher the ratio the better, however the trade off is that you will have a lower winning % of trades, in this particular example the trade ended up working. This was a high probability setup, we waited for the trade to setup properly PLUS the correct money management was in place before placing the trade. If the R:R was less than 2, it would have been wise to pass on the trade.
To Fully Understand this Key Concept read Trading in the Zone |
Trading Plan
