What is Wrong with Your Risk to Reward Ratio?

What is Wrong with Your Risk to Reward Ratio?

One of the more common trading rules that traders have in their Trading Plan is to take trades with at least a certain Risk:Reward ratio. (Or the Reward:Risk ratio, whichever you prefer.) What is this ratio, and why is it so important? That's the easy part. Most of you reading this newsletter have had the idea of a 1:3 or greater Risk:Reward ratio drilled into you from the moment you sat through your first Online Trading Academy class. The general idea is you only take trades where you will risk 1 unit for every 3 units of reward. That could mean risk 10 pips to make 30 pips, risk 50 pips to make 150, etc.

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.

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:
 

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

About Rick Wright

Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business.Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.Rick's goal in class is to accelerate your learning curve of trading, instead of figuring things out with your own money. He will show you several examples of trading mistakes that he and others have made, which cost thousands of dollars in the past so you won't make the same mistakes.You will learn how to recognize the differences between long and short term trends, where to enter trades, and where to exit based on previous price action.