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Risk Reward Ratio Validation

Risk Reward Ratio Validation

2011-12-08 23:01:00
Richard Krivo, Trading Instructor
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In our Money Management webinars we mention that a significant aspect of the rules is to always trade with at least a 1:2 Risk Reward Ratio (RRR) in place. A key aspect of this is how is a trader to know that the currency pair at least has the potential to move far enough to make the RRR valid.

Let’s take a look at the Daily chart of the EURNZD below…

Risk Reward Ratio Validation

Trade Rationale:

At the time of this chart we can see that the bias on the pair is bearish as the pair is trading below the 200 SMA and the Strong/Weak analysis showed that the EUR was weak and the NZD was stronger. As such, we would look for technical opportunities to short the pair.

Price action has been stalling just above support around 1.7080…the green line labeled Enter. Should price action take out that support level, 1.7080 or, better yet, CLOSE below that level, a trader could short the pair with a stop just above some of the recent consolidation…the red line labeled Stop.

Since our stop would be around 1.7295 and our entry was at 1.7080, the risk we are taking on the trade is 215 pips…the distance between our entry and our stop. Now let’s bring our 1:2 RRR into play. Since we are risking 215 pips we need to have a realistic potential of gaining 430 pips on the trade…twice the amount we are risking.

As we look at the chart again, since there is virtually no support between our entry and our limit, we see that we have a potential gain of 590 pips…the distance between our entry and the next level of support on the Daily chart. As such this trade more than meets the 1:2 Risk Reward Ratio requirement.

In fact, the RRR on this trade is 1:2.7.

(However, keep in mind that even though the pair legitimately has the room to move around 590 pips, does not mean that it actually WILL move 590 pips. Nothing in trading is guaranteed.)

Next: How Effective Leverage Affects Forex Profitability (41 of 48)

Previous: Arriving at a Risk/Reward Ratio

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