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The Importance of the Risk:Reward Ratio

The Importance of the Risk:Reward Ratio

2010-01-19 14:24:00
Thomas Long, Course Instructor
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Of course we can’t answer that as we don’t know how much each trader makes when they are right compared to how much they lose when they are wrong.  So the win percentage is not the most important factor in trading.  I’m sure that we would all like to win most of our trades, but if our goal is to be profitable, then there is more to the equation.  It is called the risk:reward ratio and is one of the most important aspects of money management and a key to becoming a consistently profitable trader.  Let’s take a look at some examples:
 

If you risk 100 pips and look for 300 pips in profit, your risk:reward ratio is 1:3 or one pip of risk for every three pips in potential profit.

If you risk 100 pips and look for 200 pips in profit, your risk:reward ratio is 1:2 or one pip of risk for every two pips in potential profit.

If you risk 100 pips and look for 100 pips in profit, your risk:reward ratio is 1:1 or one pip of risk for every one pip in potential profit.

If you risk 100 pips and look for 50 pips in profit, your risk:reward ratio is 2:1 or two pips of risk for every one pip in potential profit.

If you risk 100 pips and look for 25 pips in profit, your risk:reward ratio is 4:1 or four pips of risk for every one pip in potential profit.

So trader A would not be profitable using a 4:1 risk:reward ratio while maintaining a win percentage of 75%.  On the other hand, trader B using a 1:2 risk:reward ratio while maintaining a win percentage of 40% is a profitable trader.  I would recommend that new traders use a 1:2 risk:reward ratio in their trading.  If you open a trade with a risk of 50 pips, then try to get twice that or 100 pips in profit.  I would also recommend moving your protective stop up to breakeven when the market moves halfway to your target.  An example of this would be if you bought at 1.2500 and placed your protective stop at 1.2450, your risk is 50 pips.  Using a 1:2 risk:reward ratio means placing your limit order to take profits at 1.2600 for a potential gain of 100 pips.  When the market moves up halfway to your target which would be the 1.2550 level, you move your protective stop from 1.2450 up to your entry level of 1.2500.  At this point, you can only win or break even on the trade and can then spend your time looking for the next trading opportunity instead of following the current trade.  That is a good position to be in as a trader.

 

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