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Trade with at least a 1:2 Risk Reward Ratio

Trade with at least a 1:2 Risk Reward Ratio

2010-03-16 22:17:00
Richard Krivo, Trading Instructor
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Instructor's Response:

 
Your use of Moving Averages is accurate. The main thing here is that you are executing the trade in the direction of the trend and the MAs that you are using are indicating that the trend is still in force...good work.
 
However, we would not recommend using a negative risk reward ratio on a trade.  A negative Risk Reward Ratio is where a trader stands to lose more on a trade than they would stand to gain.  As in your example, selling the pair at 1.3987 with a stop at 1.4030 and a limit of 1.3968 would mean that the trader is risking 43 pips for a potential gain of 19 pips. The problem with trading this way, is that a trader must be correct in their trading assessments much more often than they are wrong to be a profitable trader.
 
Take a look at these examples...
 
Let's round off the above numbers and say the trader is risking 40 pips to gain 20 pips.  In that scenario, one losing trade wipes out 2 winning trades. Over 10 trades a trader would need to have 7 winning trades out of 10 to show a profit.  See the example below...
 
7 trades x +20 pips = +140 pips
3 trades x -40 pips =   -120 pips
                                         _______
 
                  Net Gain       +20 pips
 
 
On the other hand, when a trader employs a positive 1:2  Risk Reward Ratio (the gains will be twice the amount of the losses) we can see that now it takes two losses to wipe out one winner and a trader need only be right 4 out of 10 trades to be profitable.  See the example below...
 
4 trades x +40 pips = + 160 pips
6 trades x -20 pips =   - 120 pips
                                          _______
    
                   Net Gain       +40 pips
 
In the first example a trader must be right 70% of the time to be profitable while in the second example a trader need only be right 40% of the time to show a profit.  Given that choice, I would choose the positive 1:2 Risk Reward Ratio as, over time, that edge can produce a significant difference in one's trading results.
 
chart 3 16 10
 
 
 

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