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Why Traders Should Not Rely on Risk: Reward Alone

Why Traders Should Not Rely on Risk: Reward Alone

2014-01-21 04:00:00
Tyler Yell, CMT, Currency Strategist

Talking Points:

  • Why Risk: Reward Is Important
  • Why Risk: Reward Is A Piece Of The Puzzle Only
  • Clean Trading Systems That Utilize Risk: Reward Well

If you’re new to trading, you should always focus on trading in terms of positive risk: reward relationship. The simple but very important logic of trading with good or great risk: reward ratios is that you will have a hard time growing your account if you continue to lose large chunks of your account because of poorly planned trades. Another way to view the importance of risk: reward is in thinking that if you were the captain of a ship, you wouldn’t focus on your destination if you had a big hole in your boat, rather you’d know that your progress will be heavily hindered until you fix the leak.

Why Risk: Reward Is Important

When we set out to find the traits of successful traders, we looked at 12,000,000 live trades from October 1st 2009-September 30th 2010, and we found that traders were actually right the majority of the time, which was great, but they struggled to keep their heads above water. The reason traders were not making progress is because they were losing more money on their losing trades than they won on their winning trades. This brought about our call to make sure traders to enforce a risk: reward ratio of 1:1 or higher.

Learn Forex: The Gaping Hole in Many Trading Plans Is % Risked vs. % Gain

Why Traders Should Not Rely on Risk: Reward Alone

Source: What is the Number One Mistake Forex Traders Make?

You would be right in looking at the results of these trades and saying that traders will have a hard time making progress if they are risking on average 94 pips while taking 52 pips from the market on their winning trades. As one trader was noted, that’s a painful way to make a buck. However, you wouldn’t be that much better off if you walked away thinking that if you only set a positive risk: reward ratio of 1: 1 or higher that you’ll be set for trading greatness.

Why Risk: Reward Is a Piece of the Puzzle Only

As you’ve already seen it’s very important to ensure that you have your risk: reward appropriately set for every trade. Of course, you need to understand that the draw of risk: reward alone could pull you into trading with a weak system that has very little probability of long-term success. In fact, think about this question to help you understand that Risk: Reward is a key part but not the whole piece to the trading puzzle.

Isn’t Gambling Built On The Idea Of Attractive Risk: Reward Ratios?

As you can imagine, many people walk into casinos with the idea that they can make a killing with a small stack of cash. Of course, the casino was built with money that was fed into their system with that kind of thinking. What’s more, casinos understand market risk better than 99% of the people who walk in their doors and the reason why they have table limits and rules for each game is that they understand when the risk of playing with a customer are no longer in their favor. In fact, there are two other key aspects of trading that you need to focus on in addition to Risk: Reward to help you with your long-term trading goals.

The two other components of your trading plan should be minimizing leverage to an appropriate amount and finding a trading system that provides trading signals that you’re comfortable trading with.

Minimizing Leverage: Leverage is often more of a foe than a friend for many traders. On the surface, using leverage sounds like an exciting way to grow your account but emotionally, the greed of many traders causes them to push the envelope on available leverage. This may work well in the short term until a handful of bad trades highly leveraged pushes them past the point of return. Ed Thorp, the math instructor at MIT & hedge fund manager once said in an interview, “Any good investment, sufficiently leveraged, can lead to ruin.” Another term for this is overtrading but whatever you call it, you need to combine your knowledge of risk: reward with leverage that is manageable, which we found was around 5x total market exposure to your account balance.

Learn Forex: Correlation of Lower Leverage & Higher Relative Profitability

Why Traders Should Not Rely on Risk: Reward Alone

Source: How Much Capital Should I Trade Forex With?

Clean Trading Systems That Utilize Risk: Reward Well

There is a very clear reason why trading system is introduced last. As the referenced quote mentioned, even a good trading system can lead to ruin when too much leverage is applied. Therefore, once you focus more on using an effective risk: reward of 1: 1 or great and an effective leverage around 5x of your total account capital, then you can look to find a trading suitable that can display trade opportunities within the scope of the larger trend.

The truth about trading that many traders only learn later is that very good traders can use a multitude of any systems and still come out profitable. Just like a world-class golfer can use a variety of golf clubs to hit a winning shot, so a trader can use any variety of trend identification systems to display trend trading opportunities.

Two favored approaches that both focus on entering in the direction of the overall trend after a correction has formed is Elliott Wave which utilizes Fibonacci Retracements. While Elliott Wave can get complicated, the overall concept is rather simple as it states that a trend will be made up of 3 impulses and 2 corrections for a total of 5 moves. Corrections or counter-trend moves are your opportunity to join the overall trend. When you come across a correction that is slowing down, you can look to take that trade with a minimal amount of leverage and a positive risk: reward ratio such as 50 pip stop and 150 pip limit.

Learn Forex: Elliott Wave Can Help You Put Into Action the Traits of Successful Traders

Why Traders Should Not Rely on Risk: Reward Alone

Some traders aren’t comfortable with the subjectivity of Elliott Wave. There’s an ongoing joke that if you put a chart in front of 10 Elliott Wave technicians that you will get 10 different counts. If that sounds like you, then another good trend trading system that looks to enter on corrections within the overall trend is Ichimoku, which is meant to help you see in one glance if there is a good trend and an equally good entry at the current rates.

In Closing

This article wasn’t meant to discourage you about Risk: Reward but rather encourage you to combine the value of risk: reward with minimal leverage and a good trading system to help you identify higher probability opportunities. This will allow you to be excited about market opportunities while keeping a realistic outlook on the opportunities that can lead to success in trading.

Happy Trading!

---Written by Tyler Yell, Trading Instructor

Tyler is available on Twitter @ForexYell

To be added to Tyler’s e-mail distribution list, please click here.

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