Forex Trading Articles

REWARD TO RISK RATIO

By Dick Thompson for Forexmentor
©2012, Forexmentor.com, September 2012

In early December, David Rodriguez gave a presentation at the FXCM Currency Trading Expo titled: "What is the Number One Mistake Forex Traders Make?", which was later summarized and printed on the DailyFX Web Site.

Summary: Traders are right more than 50% of the time, but lose more money on losing trades than they win on winning trades. Traders should use stops and limits to enforce a risk/reward ratio of 1:1 or higher.

To read the article, with a link to the presentation, log into DailyFX at http://www.dailyfx.com/ and search for "Number one mistake".

Mr. Rodriquez arrived at these conclusions by analyzing the results of the trades of DailyFX clients. A number of his observations and conclusions are startling; in trades of 15 currency pairs, 14 pairs were winners ranging from 54% to 71%. One pair won only 49% of the time. As an example, EURUSD trades were profitable 59% of the time, losing only 49% of the time. And yet, these traders, as a group, lost money consistently.

While perhaps not a surprise, clearly this conclusion is profound and should be of major concern to the retail trader. However, I take issue with the statement of the summary that states: Traders should use stops and limits to enforce a risk/reward ratio of 1:1 or higher. This is only my personal opinion, but I find this simplistic and ambiguous, even though it is a staple of almost every basic tutorial of forex trading.

What I take issue with is the fact that risk, and only risk, is under the control of the trader. Let me rephrase that; risk is the only trading parameter that the trader can control.. Think about that for a moment. When you place a stop on your trade you have absolutely controlled your risk. If your trade moves against you, and you are stopped out, you will lose exactly the amount of money that you had pre-determined that you were willing to lose. You knew it up front, you controlled it and there was no question of it ever being more than you were willing to allow. Compare that to your reward. Can you control your reward? Can you predetermine that a winning trade will have a reward of $XX or a ratio of reward to risk of 1:1? Or any other number? Absolutely not. If we are so lucky as to have our trade move favorably, we will never know how far it will move or what path it will take to get there.

So to say that we should use stops and limits to enforce a risk/reward ratio of 1:1 or higher, is in my opinion just plain hooey! You cannot do it. Here is a web quote from someone who runs a training program for forex traders: The reward is the gain in the currency price that the trader is hoping to earn from the currency price movement. Well, golly! I hope to make 1000 pips on every trade! My reward to risk ratio is really large.

That is not to say, however, that we cannot choose to trade with a methodology that gives us an edge that price will move in our preferred direction. In addition, we can analyzed the market conditions to determine where price might first falter, which can be seen as our minimum expected reward. If that minimum expected reward is equal or better than the predetermined risk that we have set, then we have a trade that meets our minimum reward to risk criteria and we should consider taking the trade.. That is what the conclusion of this study should have stated. Minimum expected reward does not "enforce" a certain result, but it does give you a probability of achieving a certain result. And that is the best we can do. Fortunately, there are Forex mentors and teachers that understand this and we are fortunate to have some of them here at ForexMentor.

I like to think of price as following Newton's First Law of Motion: every object in uniform motion tends to remain in that state of motion unless an external force is applied to it. To me, that external force is either support or resistance. So, if we trade with a strategy that we know has an edge and that edge will allow us to reasonably expect a movement in a given direction, the question then becomes how far can we expect it to move. The answer is until an external force is applied to it; until it encounters support or resistance. We are all familiar with the various support/resistance characteristic of the market and we all have favorites.

For instance, I favor old highs and lows that have not been recently molested by price; Fibonacci levels; and to a lesser degree, trend lines. I do not regularly use Pivots or Moving Averages. I also like to see a confluence of more than one support or resistance level which I think strengthens the probability of price respecting it. So once I have decided to entered a trade, I determine where I will place my stop, and then I look to where price will first encounters support or resistance which could bring it to a stop. That will be my minimum expected reward for a successful trade and it must give me an acceptable reward to risk ratio. It does not enforce a reward to risk ratio, but it is a realistic expectation, based on probability. And that is sufficient.

Every trader has their favorite way of identifying where price might first falter. They should use that concept to determine their expected reward for a trade and use that as a means of calculating reward to risk ratio. Then, and only then, can they reasonably expect to consistently trade with a reward/risk ratio of 1:1 or higher.

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