Using Risk Reward Ratios in Trading

Student’s Question:

I see the logic behind the risk reward ratio and the 5% rule, but why must there be an upside limit other than to see if the momentum is sufficient? Why not just enter the trade with a trailing stop? Risk is reduced as the trade matures, and there is a possibility for more pips. What am I missing?

Instructor’s Response:

You make a valid observation…

To set a risk reward ratio, an upper limit must be present so that the Risk Reward Ratio can be determined in the first place. Both the stop and the limit must present for the ratio to exist.

Another issue has to do with emotions. Without a limit in place, should the trade surpass the 1:2 ratio level, a little bit of greed (or a lot of it) may kick in and the trader may decide to let the trade run. Not having a predetermined exit strategy, the trade may retrace to a level below where the limit would have been set initially, thereby cutting into potential profits. This can occur even with a trailing stop in place. Depending of course on how the stop was set to trail price action.

Here are two things that I do in this situation...1) When/if the trade reaches half the distance to the limit (profit target) I have set, I move the stop to breakeven thereby eliminating risk on the trade.2) I will usually trade multiple lots. This affords me another option. I can do what I suggested above and move my stop to breakeven half way to my profit target. In addition, I can close half the positions that I am trading when the 1:2 RRR is reached to lock in profit.

On the remaining open positions I then move the stop to breakeven and manually trail the stop at a very respectable distance should the trade continue to progress in the intended direction. As long as the trade continues in my direction, I can continue to trail my stop and capture additional profit.