Why Choosing a Smart Risk:Reward Ratio

In this post, we will elaborate about the importance of a correct choice of the Risk:Reward ratio.

Without a doubt, the major goal of Trading is to increase the value of your Trading Account. That implies that the overall result of your trades is positive. For that to happen, the first thing a trader has to do is to protect his/her capital. One must never forget that it is far better to lose one entry than to rush in and let emotion hurry us into a trade without knowing and measuring the exit scenario. That can only result in a (very) near and dark future.

Therefore, and beyond an attentive market analysis and a proper Risk Management, another very important issue is an adequate choice of your Risk:Reward ratio. This means, it simply doesn't matter if your entry is perfect when your potential reward isn't that appealing.

Since Trading is a matter of probability and the Professional Trader is supposed to make the most out of every factor that will increase the Trader's Edge, all these parameters must coexist:

- A Trading System built on tested Strategies with a high success rate;
- Proper Risk Management;
- Risk:Reward ratio according to the previously set rules and updated Market Analysis.

These are the 3 factors that will provide you with the Trader's Edge and an increasing success in Trading.

Let's focus on the advantage brought by a smart approach to the R:R ratio, simply because this will probably be the main responsible for your account capital increase.

The first question that needs answering, and has to be made before placing the Trade, is:

What is my Take Profit for this particular Trade? The answer relies on the strategy you are using. What we want to point out is that it doesn't matter if the price got to an extremely favorable/positive position. The only thing that must be analyzed is when (and why) you closed the Trade.

One thing that happens frequently is when you see a Trade reaching 1:3 or even more and, given that fact, as an amateur, the trader feels overconfident (greedy?) and wonders if the move will go on. What happens next is that price acts according to its usual cyclicity and starts retracing. This is generally when the amateur traders get scared and close the trade, only to watch the trend continue and reach 1:5 or even higher potential profits.

The important thing to remember is that this only happens when there wasn't a predefined Target, therefore the Trader had to analyse the market after his order was triggered. It will always be harder to maintain the discipline if you analyse the future scenario while there's an active trade. It will be much easier for the emotions to get in the trader's way if all the possible scenarios weren't fully foreseen BEFORE the order was activated.

In our opinion, this is undoubtedly the hardest part of Trading - we feel that our analysis becomes compromised immediately after the order is triggered. And that is why the Target and/or the Trade Management must be decided before the Trade takes place. It will be the difference between a Strategy and a Feeling.

Traders in general know exactly that every Take Profit for every trade is going to be a minimum of 1:1 and an ideal of at least 1:2. Why? Again, it is a matter of taking the (mathematical) Edge into your Strategies.

Let's now take a look at an example of 5 Trades taken with different R:R ratios:

R:R 1:1
1st - winner; Result +1
2nd - winner; Result +1
3rd - loser; Result -1
4th - loser; Result -1
5th - loser; Result -1
5 trades overall result: 2 victories + 3 defeats = - 1

R:R 1:2
1st - winner; Result +2
2nd - winner; Result +2
3rd - loser; Result -1
4th - loser; Result -1
5th - loser; Result -1
5 trades overall result: 2 victories + 3 defeats = + 1

R:R 1:3
1st - winner; Result +3
2nd - winner; Result +3
3rd - loser; Result -1
4th - loser; Result -1
5th - loser; Result -1
5 trades overall result: 2 victories + 3 defeats = + 3

What we want to demonstrate with these numbers is that even if the number of losers is bigger than the number of winners, the result can still be positive. A proper R:R choice can make all the difference between a negative and a positive period in Trading.

Also, such as the Stop Loss (SL) should always be in a position that invalidates our entry assumptions (which means the SL should be in a place that, if price action reaches it, our analysis just didn't relate to the market behavior), so should our Take Profit (TP) always be in a 'logical' level.

Ie., if for price to reach our TP it has to overcome a strong Horizontal Level or something really unexpected has to happen in order for our goal to be reached, maybe we're being too ambitious regarding the present market situation. It is one thing to choose an ambitious TP, another different thing, is to let greed define our targets.

In conclusion:

- All the concepts developed throughout this post are once again directions that a Trader must follow in order to take full advantage of the professional Trader's Edge;

- It is perfectly natural to lose a few Trades and still make money;

- Once you can put together the Discipline, a valid Trading System, the correct Risk Management, and a proper R:R choice, you will be able to achieve the effective consistency and therefore the desired results.

Happy Trading!

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Posted on 2013-08-16, By: Jorge Moutinho *

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Note: The content of this article solely conveys the opinion of its author, Jorge Moutinho