MoneyTec Traders Community Forum - View Single Post - Why we are taught to set risk/reward ratio larger than 1

James · 22-10-2003, 04:53

My 2 cents worth:

Risk should be measured in at least 3 ways.

First there is the monetary risk which you expose yourself to in the trade. This can be measured in terms of dollars, percentage of equity or such-like. In a classic case of a clear up-trend, for example, one should buy as close to S/R levels as possible, in order to minimise this component of risk. These levels can be defined by whatever system you use to trade, such as horizontal lines, trend lines, Fibonacci levels, moving averages or over sold oscillators. Naturally, the closer you can get to these levels before buying, the lower your monetary risk is before you know you are wrong.

Secondly, the risk/reward value is important. I try to risk less than one half to one third of the projected gains of the trade. The projected gains are measured by the distance to the next resistance level, once again determined by your system using indicators as above.

The third and most overlooked (and most difficult to calculate/estimate) component is the probability of being wrong. In a hypothetical (and impossible) case of an “un-breakable” level being determined, one could use a much larger % risk and much lower RR ratio, and still have a much lower risk on the trade. For example, in an uptrend where a particular support level is so strong and so obvious, one could enter the trade say 100 or 200 pips higher up, with stops well below the determined support level. This higher entry would have to be justified by other reasons of course, or it would be foolish. The risk on this trade in terms of % or RR ratio may be high, but the chance of being stopped out below the major support may be very low. Multiply the three factors together, and you may come out with an acceptably low number, prompting you to enter the trade.

The difficulty is in determining this elusive third risk factor. Of course, no levels are unbreakable and often when they seem that way, that’s when they break! The point is, though, that the probability of being wrong can sometimes be low enough to allow higher risk% and lower RR ratios.

Best case scenario is when you can trade from close to a really strong support level, with a clear trend, with high projected gains and a low probability of being wrong. These scenario’s unfortunately are rare, forcing traders to make “less than perfect” entries a lot of the time.

22-10-2003, 04:53	#24
James Team Forex Join Date: May 2003 Posts: 1,229 Downloads: 0 Uploads: 0 Rep Power: 0	risk reward My 2 cents worth: Risk should be measured in at least 3 ways. First there is the monetary risk which you expose yourself to in the trade. This can be measured in terms of dollars, percentage of equity or such-like. In a classic case of a clear up-trend, for example, one should buy as close to S/R levels as possible, in order to minimise this component of risk. These levels can be defined by whatever system you use to trade, such as horizontal lines, trend lines, Fibonacci levels, moving averages or over sold oscillators. Naturally, the closer you can get to these levels before buying, the lower your monetary risk is before you know you are wrong. Secondly, the risk/reward value is important. I try to risk less than one half to one third of the projected gains of the trade. The projected gains are measured by the distance to the next resistance level, once again determined by your system using indicators as above. The third and most overlooked (and most difficult to calculate/estimate) component is the probability of being wrong. In a hypothetical (and impossible) case of an “un-breakable” level being determined, one could use a much larger % risk and much lower RR ratio, and still have a much lower risk on the trade. For example, in an uptrend where a particular support level is so strong and so obvious, one could enter the trade say 100 or 200 pips higher up, with stops well below the determined support level. This higher entry would have to be justified by other reasons of course, or it would be foolish. The risk on this trade in terms of % or RR ratio may be high, but the chance of being stopped out below the major support may be very low. Multiply the three factors together, and you may come out with an acceptably low number, prompting you to enter the trade. The difficulty is in determining this elusive third risk factor. Of course, no levels are unbreakable and often when they seem that way, that’s when they break! The point is, though, that the probability of being wrong can sometimes be low enough to allow higher risk% and lower RR ratios. Best case scenario is when you can trade from close to a really strong support level, with a clear trend, with high projected gains and a low probability of being wrong. These scenario’s unfortunately are rare, forcing traders to make “less than perfect” entries a lot of the time.