Guest Commentary: Don’t Risk Your Reward
Do you check out your risk reward ratio before placing a trade? Good. But do you stretch the stop loss or take profit points just to fit the desired ratio? Not so good.
Here are some common mistakes regarding the risk reward ratio, and some tips on how to do it the right way.
A risk-reward ratio in forex is the number of pips that you risk if the price reaches the stop loss point, versus the number of pips that you’ll gain if the price hits your take profit point.
Optimally, the reward side should be 3 times the size of the risk side. Also 2:1 is OK. A better ratio means in theory that less winning trades are needed in order to be a profitable trader. This is assuming that you don’t take the profit before it hits the take profit point, and hopefully you aren’t moving your stops, which is far more dangerous. Don’t move your stops!
So, now you are aware and incorporate this factor into your system. Great!
The problem begins when you are itching to trade. This happens to many traders, too many times. So, you use your system to find a potential trade. And now you make the simple calculation of the risk-reward ratio. And unfortunately, it falls short of your target.
What do you do?
- Squeeze your stop loss: Wrong. This will improve the ratio, but if the pair doesn’t go in your direction soon enough, it will hit your stop loss soon enough. You’ve ensured your loss.
- Widen the take profit point: Wrong. This will improve the ratio as well and has a lower chance of hitting the stop loss too soon. But if your system was good before incorporating the risk-reward ratio, the price has low chances of hitting the take profit. The wind needs to blow in your direction very strongly.
- Walk away: This is the right thing to do. Your system got a nice setup, but the ratio was poor. Just walk away. This trade just isn’t good enough. Other trades that fit your system AND provide a good risk-reward ratio will come along.
How are you dealing with the risk reward ratio?
Further reading: Get the Q4 2011 Forex Outlook
By Yohay Elam, Forex Crunch
DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.