## Options Education

### What is Wrong with Your Risk to Reward Ratio?

What is Wrong with Your Risk to Reward Ratio?

Now, quick quiz. What are two of the main benefits of taking only trades with a Risk:Reward ratio of 1:3? The first I'll mention is the quality of the trades you take will be better. These 1:3 trades don't show up every thirty seconds, so being more selective in your trading is a good thing.

The second reason for taking only 1:3 Risk:Reward ratio trades is the pure mathematical fact that you don't have to be right very often to make money, let alone break even! Here is a quick demonstration:

Figure 1

As you can see with the column on the left, the trader wins on 1 out of 3 trades (2 losses) and still makes a little bit of money. The column on the right the trader only makes money on one out of four trades, yet is still flat! There are not too many jobs on the planet where you can be right only 33% of the time and still make money.

Now, here comes the hard part. The Risk:Reward ratio of 1:3 may be your INTENDED outcome for your trades, but what is the REAL outcome? In class, we'll occasionally have a student with trading experience who has already heard of the 1:3 Risk:Reward ratio and has applied it unsuccessfully in his trading. My response is always, "What is the real outcome of your trades?" For example: With an intended 1:3 and 10 trades, perhaps he lost on 5 trades and won on 5. This would be the result:

Intended:

Trades 1-5: Losses of 10 each for a total of 50.

Trades 6-10: Wins of 30 each for a total of 150, with a net result of +100.

But what if the REAL outcome was as follows:

Figure 2

For a net result of flat. What is the real problem here? In this hypothetical example, the trader may be having trouble "letting his winners run." Another issue may be that with a small string of losses, this frustrated trader just wants to see a couple of profitable trades in his history. Whatever the reason for this, you must figure it out! As I have stated before, trading is a simple job just not an easy one. If you find yourself in this same situation, you must examine your trades AFTER THEY ARE COMPLETELY DONE. Look back at the chart and see what happened after you exited. Very often the trade will eventually hit your final target even though you may have exited early. By studying what happened to the market after you exit the trade, you should be able to more quickly determine if you are "good" at recognizing the 1:3 Risk Reward ratio trades. When you realize that you are good at them, it will be a lot easier to let those winners run!

Until next time,

Rick Wright

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