Understand How to Use Risk to Reward Ratio
Many new traders think that for each trade a good entry into the markets is the essential key to success. Most of them are wrong, unfortunately. What is more important is trading with a good risk to reward ratio. A risk to reward ratio compares the potential for reward with the potential for loss. A good ratio has a high probability of making a profit.
Risk is measured by counting the number of pips between the forecasted entry price and the forecasted price at which you want to exit the market in case of a losing trade. A trader must view each trade as a business transaction. Risk is just a measure of how much you can lose in a trade.
Reward is calculated by the pips between the forecasted entry price and the forecasted price at which you would want to exit the market in case of a winning trade. Reward is the expected number of pips that you want to make in a trade that will be a winner.
To manage risk properly, you need to look for high probability trades that have a risk to reward ratio of 1:2 or greater. This depends on the time frame that you want to trade. For example, if you are a day trader and you are looking for making only 30 pips in a trade, a stop loss of 15 pips is sufficient for the risk to reward ratio of 1:2.
However, suppose you are a swing trader or a position trader with a longer time frame. Your profit potential will be more on a longer time frame. Suppose you choose 200 pips as your expected profit. You will need to set your stop loss at 100 pips.
Retracements on shorter time frame are much smaller. Retracement on the larger time frame is much bigger. The reason that you need to set a higher stop loss on a larger time frame is that small trends occur within the larger trend. In order to be not stopped out of the trade, you need to calculate your risk to reward ratio appropriately. Due to smaller trends in the larger trends, your trade is going to be recycled.
Many traders agree that next to maximizing profits, the second most important thing for them is minimizing losses. A trading system that wins only 50% of the time on average can still be profitable. Most of the traders want to make money but dont know how to protect what they currently have.
You have 50/50 chance of market going your way just like flipping a coin. In case, the trade does not develop in your favor, you should cut your losses by using stop losses. In short, you cut your losses and let your winners run. This simple 50/50 strategy earns a profit even when a novice trader might experience a loss.
Consider different risk to reward ratios. How much you need to win to break even for each ratio? For a 2:1 risk to reward ratio, you need 67% winners to become profitable. For a 1:1 risk to reward ratio, it means just 50% winners to become profitable. 1:2 ratio means only 33.5% winners for profitability. Never ever trade when the risk to reward ratio is more than 1:2.
