Whenever the concept of Money Management comes up, the topic of the Risk Reward Ratio must be covered as well.
In a nutshell, the Risk Reward Ratio (RRR) is the size of the limit relative to the size of the stop. For example, if the stop is 75 pips below the entry in a long position, for a 1:2 RRR the limit would need to be 150 pips above the entry…twice the amount of the stop.
To set a risk reward ratio, a limit or profit targetmust be present so that the Risk Reward Ratio can be determined in the first place. Both the stop and the limit must be present for the ratio to exist.
By trading with at least a 1:2 RRR in place, a trader need only be right in 40% of their trades to be profitable. This works out since they will gaining twice as much on their winning trades as they will be losing on their losing trades.
For example, let’s say a trader takes 10 higher probability trades each with a 50 pip stop and a 100 pip limit. If they lose 6 of those trades they will have lost 300 pips. (6 x 50 pips = 300 pips) On the 4 trades that they win they will have gained 400 pips. (4 x 100 pips = 400 pips) The result is a net gain of 100 pips.
Another reason for setting a RRR 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. (True…this may ultimately work in favor of the trader.)However, by not having a predetermined exit strategy, the trade may retrace away from thepointat which the limit would have been set initiallythereby cutting into or completely negating any potential profits.
Here are two things that I do regarding a Risk Reward Ratio...
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. If the pair retraces and hits the stop, I will be stopped out at breakeven…the point at which the trade was entered. While the trade will not show a gain, it will not show a loss either.
2) I will usually trade multiple lots as 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, by trading multiple lots, I can close half the positions that I am trading at that point as well to lock in profit.
On the remaining open positions I alreadyhave the stop at breakeven. I then will 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.
