If you no longer consider yourself to be a novice trader then you’ve probably suffered some trading losses, you’ll have trader scar tissue imprinted on your conscious mind and gained valuable experience during your journey. Whilst you’ll also quickly realize that trading doesn’t necessarily involve having (or struggling to find) a trading technique/method or edge, that has a high probability of getting the direction of the market right. Even getting that entry right with a high probability set up, is no guarantee of success. Unless we solve the persistent problem and equation of risk vs. reward, then getting the entry right and having a set up with high probability, will not result in success and ultimately profitability.
Successful traders will recite that they repeat the same processes time after time in order to take money out of the forex market, this process forms part of their edge. They have very little variance; their set up occurs, either through automation or manual trading and the trade is taken without hesitation, and the same risk – reward parameters are employed with each trade. Finding the balance between our own tolerance of risk and reward and our edge/high probability set up, is one of the biggest challenges we face as traders. And in this article we intend to walk through an illustration of how we can tackle the risk versus reward challenge and conundrum.
Setting the risk – reward ratio
One of the biggest challenges we face, when attempting to set a risk reward ratio for the trades we take, is that there are no hard and fast rules, there are no historical precedents, that suggest that (for example) when we’re risking 1% of our account size per trade, we should be aiming for, or can reasonably expect a return of 3%. There are zero guarantees that the market will deliver us any reward for our risk, let alone our arbitrary 3% target. Moreover, if you’re using a day trading strategy and place your stop at a 1% risk level, then expecting a reward treble the value of your risk at 3% during any trading session, or daily sessions on a regular basis, is perhaps over ambitious.
Can we therefore establish a realistic risk versus reward ratio, with respect to the trading style we employ? Should we use a higher risk vs. reward ratio on a swing trading strategy and a lower ratio on a day trading strategy? Yes is the basic answer to the questions.
As we’ve already come to realize, for a forex currency pair to move 1% in a day, is an unusual occurrence. We can employ our own research into what an average movement for a pair is and what would be considered unusual. We know that markets range the majority of the time, some research suggesting up to 70%+ and they trend for the remainder. But even during these times it’s tricky to gauge an exact measurement for what represents an average move for a currency pair, when judged over a reasonable period of time.
If a currency pair rises circa 0.3% in a day, it’s generally close to breaching or on the first line of resistance. 0.6% is close to R2, even a move of this magnitude isn’t observed many days. A currency pair breaching R3 doesn’t happen often, perhaps once a week/in a day. Similarly S3 may be only breached once a week and both bearish and bullish movements are generally reactions to economic calendar releases either beating, or missing forecasts by some distance.
It’s therefore obvious that we can match the percentage we’re prepared to risk, versus our potential reward and the likelihood of a currency pair or security moving over a period of time. By utilizing a swing trading strategy can weregard a 2% market move as being realistic, can we therefore match our 1% risk to chase a 2% reward? Again; if we historically examine our charts or read fundamental analysis, we’ll discover that a 2-3% move in a month represents a significant trend.
Whilst our account size risk doesn’t necessarily relate to the percentage movement in the market, our reference to pivot points offers up an interesting comparison for traders to pontificate over; if R2 or R3 represents a significant move and should indicate a 0.6% to 1% move on a day, could we place our stop in accordance with this movement? Looking at the daily pivot point as the starting point of the day’s price, if we placed our stop at S1, entered our long trade at R1 and placed our take profit limit order at R3, then we’d be aiming for roughly 2:1 return on our risk.
This example is by no means a recommendation, we’re using it as a straightforward example of how to use conservative Risk: Reward, without applying excessive risk. We could risk 1% of our account at S1, hoping to make gains of twice our risk, should price breach R3. An example that most experienced traders would not regard as being unrealistic.
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