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Risk~VS~Reward
Here's a great article courtesy of BigTrends.com
It's geared more towards equity trading but it has just as much relevance to FX. It deals with Risk:Reward how important it is to factor in the outcome probabilities of a given trade(s) when calculating it.
This basic concept is absolutely fundamental extremely important! - but it is often overlooked or misunderstood.
Article:
The concept of a risk/reward ratio is pretty straight-forward; for any given trade you're targeting a certain amount of gain while setting a stop-loss limit if the trade goes the other direction instead. This is a critical concept for any trader to grasp as the idea is to establish the potential loss to see if it justifies the potential gain. Of course in all cases you want your reward to be at least a little better than your risk so you set your targets stops accordingly. A good rule of thumb is to seek a return of three times as much as the amount risked making the reward/risk ratio 3 to 1. But it's equally common to see reward/ratios of anywhere between 2 to 1 4 to 1. Let's go through a real example.
Say we're buying XYZ shares at $36.00. We think XYZ will move to $46.80 for a 30% gain we're willing to risk a 10% loss in the attempt to get that 30% gain. A 10% loss on $36.00 (initial investment) means shares would fall to $32.40 before we threw in the towel closed out the position. Our potential reward is 30% but we're risking a 10% loss. What's the reward to risk ratio? Well 30% divided by 10% equals a 3 to 1 reward/risk ratio.
So as long as you're rewards are bigger than your risks over time ( enough trades) you'll make money right? Wrong. Unfortunately too many traders automatically set up a 3 to 1 ratio when setting price targets stop losses on any of their trades. But they're forgetting something very important. Just because your profit target is three times as big as your risk doesn't mean you'll ever actually hit that target. You also have to factor in the likelihood of a successful trade. Let's take a look at why.
Let's stick with the assumption that our optimal reward/risk ratio is 3 to 1. Let's also assume you've developed a trading system (or you're able to pick stocks) that produces one winning trade for every four trades. So your win/loss ratio is 1 to 4 (25%) while your reward/risk ratio is 3 to 1. Do you think you'll make money with that system? Nope - for every trade that gains 30% you have three more trades that lose 10%. The rewards were three times as big as the risk but it didn't create one penny in profit! The best you could hope for is to break even.
So how does one measure the real reward-to-risk ratio? You have to factor in the odds of a winning trade into the potential gains or losses. Again we'll illustrate it with an example. Say you've found a stock you think will move 20% higher you're willing to risk 10% to enter that trade. You're target is 20% above your entry price your stop loss is 10% under your entry price. With a reward/risk ratio of 2 to 1 this trade doesn't necessarily seem all that great. But what if the trading system had a success rate of three winners for every four trades? You'd have a 75% chance of making 20% while only a 25% chance of losing 10%. With that particular trade your real reward-to-risk ratio would be about 6 to 1.
The point is don't fall into the trap of setting targets stops based on a predetermined risk/reward ratio. Big rewards small losses are worthless if the system is a net loser. Rather focus on the actual risks rewards of a total methodology. This will also you to determine just how successful your trading system or stock picking really is which is something you should know anyway.
Good Trading
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