Risk to reward ratio in trading is often overlooked but is one of the most important factors in a trading plan. While some traders may think winning percentage is the most important or the indicators, actually it is money management and risk to reward ratio.
Actual Risk to Reward Ratio
Here is a great example on the Euro chart this morning from about 1:30 am New York time to 6:00 am New York time. Taking every single trade (no filtering using a higher timeframe), there were eight trades. Five trades lost money and three trades mad money. The trade results were:
- -6 pips
- +9 pips
- +13 pips
- -6 pips
- -7 pips
- +4 pips
- -1 pip
- -3 pips
A pretty dismal morning but every trader will go through periods of “dismal” days. After all, the markets are ever changing and, as traders, we never know what the day will bring. We simply follow the rules and take it as it comes. However, in this case, even though the day was quite disappointing, the trader is up three pips or $37.50. Calculating commissions at $5 a round turn, the trader’s account would be down less than ten dollars. What made the difference?
The difference was in profits — the trader was taking what the market offered with a goal of achieving at least a 1 to 2 risk to reward ratio. As you can see, the markets did not always give a 1 to 2 risk to reward ratio. However, using the aggressive stop in the strategy, the trader took as much as possible when the markets began moving in his direction. This prevented the trader from giving back to much in profits, which allowed him to easily recoup his losses. The average loss was 4.6 pips and the average win was 8.66. The trader was able to keep his losses low and his wins greater than the losses.
By incorporating risk to reward ratio in your trading plan, you increase the likelihood of becoming profitable regardless of what your winning or losing percentage is. You are trying to take the most out of the trades that go your way, while minimizing the losses on the bad days.