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What do you think of Risk/Reward ratio?

  • #1
  • First Post: Dec 6, 2007 1:39am Dec 6, 2007 1:39am
I have read a lot about risk/reward ratios. And it makes sense to me. However I find it hard to get a good risk/reward trade. If for example I want to play 1:1 risk reward then I will risk 40 pips to make 40 pips. That is not hard to do. Even 1:2 risk reward it not all that difficult. Once a week you will get a reward of 80 pips if you risk 40 pips. But if I want to play 1:3 it is a bit harder. Not every trade gives you a reward of 120 pips if you risk 40 pips.

Is there anyone who is good at playing risk/reward trades and would not mind to share his/her knowledge?
  • #2
  • Dec 6, 2007 2:12am Dec 6, 2007 2:12am
It's all completely up to you and your trading style. you may trade short term and aim for 60 pip wins, while risking 30 pips, that would be 1:2 risk/reward. Or you could be a long term trader and risk 200, and expect to get 800+ over the next couple months, which is 1:4. The right R:R is whatever you are comfortable with. don't forget to factor in the spread.
  • #3
  • Dec 6, 2007 2:13am Dec 6, 2007 2:13am
http://www.investopedia.com/articles...rofit_loss.asp

This is also a bit of a a different approach, take a look at it.
  • #4
  • Dec 6, 2007 2:50am Dec 6, 2007 2:50am
There are other ways to manage risk, but stop loss orders seem to be the most popular among retail forex traders, probably because of their simplicity. There are arguments against using them altogether, except for emergency exits, but on the other hand you also have people who swear by their stop losses.

Rigid RR rules are not perfectly compatible with certain trading styles. For example, systems that use dynamic support/resistance levels for entry/exit (such as MAs, trendlines etc.) can suffer if you try to apply strict RR rules and rigid entry/exit points. Also, if you scale into and out of positions, or you trail stops, your RR calculations become more complicated (but not unmanageable).

In any case, if you are using this method, don't worry about the actual RR ratio until you've already determined your entry and exit points. Otherwise you might end up pulling your stop loss orders in too close in order to get a better RR, with detrimental effects to your win percentage. Only after choosing entry/exit points, take a look at your RR to see if you like it enough to put your money at risk.
  • #5
  • Dec 6, 2007 4:08am Dec 6, 2007 4:08am
Quoting fierceman
There are other ways to manage risk, but stop loss orders seem to be the most popular among retail forex traders, probably because of their simplicity. There are arguments against using them altogether, except for emergency exits, but on the other hand you also have people who swear by their stop losses.

Rigid RR rules are not perfectly compatible with certain trading styles. For example, systems that use dynamic support/resistance levels for entry/exit (such as MAs, trendlines etc.) can suffer if you try to apply strict RR rules and rigid entry/exit points. Also, if you scale into and out of positions, or you trail stops, your RR calculations become more complicated (but not unmanageable).

In any case, if you are using this method, don't worry about the actual RR ratio until you've already determined your entry and exit points. Otherwise you might end up pulling your stop loss orders in too close in order to get a better RR, with detrimental effects to your win percentage. Only after choosing entry/exit points, take a look at your RR to see if you like it enough to put your money at risk.
The best place to enter a trade then would be to enter close to a trendline or support/resistance level. That way your stop loss is not hundred of pips away.

That way you boost your risk/reward possibilities.

What i have done the last few months is so ask myself the next question: "will this trade give me a potential 100 pips?". If the answer is no, then i dont take the trade. That keeps me disciplined so i dont just take any trade for the sake of trading. Also i like the market to come to certain levels that i am comfortable with. Then it is easier for me to decide wheter i wanna trade or not. For example in the last few weeks i didnt consider going long on eur/usd because to my mind there was not a lot of pips left once price hit 1.5000. But there was a lot of pips to the downside. So i took a short trade at 1.4845. And it has paid off
  • #6
  • Dec 6, 2007 5:14am Dec 6, 2007 5:14am
Quoting Time
I have read a lot about risk/reward ratios. And it makes sense to me. However I find it hard to get a good risk/reward trade. If for example I want to play 1:1 risk reward then I will risk 40 pips to make 40 pips. That is not hard to do. Even 1:2 risk reward it not all that difficult. Once a week you will get a reward of 80 pips if you risk 40 pips. But if I want to play 1:3 it is a bit harder. Not every trade gives you a reward of 120 pips if you risk 40 pips.

Is there anyone who is good at playing risk/reward trades and would not mind to share his/her knowledge?
The rish/reward must be coupled with the win/loss probability of your own strategy...When those 2 factors are coupled together, you get the expectancy of your strategy...I am not sure who was the first one to introduce this concpet...Expectancy looks like this:

Expectancy = (Average win ratio x Average profit) - (Average loss ratio x Average loss)

If your strategy produces 70% winners and 30% losers and your risk/reward is 1:2 then:

Expectancy = (0.7 x 2) - (0.3 x 1) = 1.4 - 0.3 = +1.1

When you are having a positive expectancy it means that this strategy will make money over the long run...When you are having a negative expectancy, it means that this strategy will lose money over the long run...

Generally speaking a trading strategy is considered good if it has a positive expectancy above +0.5...


Thanks,

Nader
  • #7
  • Dec 6, 2007 5:33am Dec 6, 2007 5:33am
Quoting narafa
The rish/reward must be coupled with the win/loss probability of your own strategy...When those 2 factors are coupled together, you get the expectancy of your strategy...I am not sure who was the first one to introduce this concpet...Expectancy looks like this:

Expectancy = (Average win ratio x Average profit) - (Average loss ratio x Average loss)

If your strategy produces 70% winners and 30% losers and your risk/reward is 1:2 then:

Expectancy = (0.7 x 2) - (0.3 x 1) = 1.4 - 0.3 = +1.1

When you are having a positive expectancy it means that this strategy will make money over the long run...When you are having a negative expectancy, it means that this strategy will lose money over the long run...

Generally speaking a trading strategy is considered good if it has a positive expectancy above +0.5...


Thanks,

Nader
Thank you. That is good insight
  • #8
  • Dec 6, 2007 1:02pm Dec 6, 2007 1:02pm
Quoting narafa
The rish/reward must be coupled with the win/loss probability of your own strategy...When those 2 factors are coupled together, you get the expectancy of your strategy...I am not sure who was the first one to introduce this concpet...Expectancy looks like this:

Expectancy = (Average win ratio x Average profit) - (Average loss ratio x Average loss)

If your strategy produces 70% winners and 30% losers and your risk/reward is 1:2 then:

Expectancy = (0.7 x 2) - (0.3 x 1) = 1.4 - 0.3 = +1.1

When you are having a positive expectancy it means that this strategy will make money over the long run...When you are having a negative expectancy, it means that this strategy will lose money over the long run...

Generally speaking a trading strategy is considered good if it has a positive expectancy above +0.5...


Thanks,

Nader
Keep in mind that getting a statistically reliable expectancy value can be tricky. Your system needs to be tested over a large sample of trades for it to be valid, and longer-term (swing+) discretionary traders can have a rough time getting there. 2-3 trades per month is not going to yield a viable expectancy for whiiile plus a discretionary strategy has an extra degree of uncertainty about it because it can vary with the trader's mood, knowledge, hang over, etc... In other words, it is more susceptible to uncontrolled "external" variables.

So the expectancy value works beautifully for automated scalping systems and short timeframes, but for some types of traders it is more an academic pursuit than a real, useful number (this is where the persistent people start doing manual backtesting of their discretionary swing trading system on data from the 1980's - can you think of a better way to spend the weekend?).

Perhaps we could go through some calculations to determine at which point an expectancy value becomes reliable... But I'm tired and I need to look that up before posting. Maybe tomorrow. Cheers.
  • #9
  • Dec 6, 2007 7:49pm Dec 6, 2007 7:49pm
Quoting fierceman
Keep in mind that getting a statistically reliable expectancy value can be tricky. Your system needs to be tested over a large sample of trades for it to be valid, and longer-term (swing+) discretionary traders can have a rough time getting there. 2-3 trades per month is not going to yield a viable expectancy for whiiile plus a discretionary strategy has an extra degree of uncertainty about it because it can vary with the trader's mood, knowledge, hang over, etc... In other words, it is more susceptible to uncontrolled "external" variables.

So the expectancy value works beautifully for automated scalping systems and short timeframes, but for some types of traders it is more an academic pursuit than a real, useful number (this is where the persistent people start doing manual backtesting of their discretionary swing trading system on data from the 1980's - can you think of a better way to spend the weekend?).

Perhaps we could go through some calculations to determine at which point an expectancy value becomes reliable... But I'm tired and I need to look that up before posting. Maybe tomorrow. Cheers.

Totally agree....The previously mentioned equation for the expectancy is just a theoritical one....Welcome to real life...Text book statistics is something and the wild real life of trading is another thing...Things to be taken into consideration, commission costs, slippage, market volatility and most importantly position sizing...

Theoritically, any sample, whatever large, won't be enough...In my opinion, one should insert an error margin against the final result..If the sample is small, the error margin must be large and as the sample approaches infinity, the error margin must tend to zero...

Estimating the expectancy of a trading strategy is not a 1 post discussion for sure as you mentioned...My post was just an insight...


Thanks,

Nader
  • #10
  • Dec 7, 2007 4:52pm Dec 7, 2007 4:52pm
I certainly do not pick my trades based on risk/reward ratio. I can say that there are times and places with possibility of better reward but is it 2:1 or 5:1 is a guessing game. I only know one thing for sure, when I enter a trade I know how much I risk. If I enter long with 15 risk I do not wait for a 30 gain to close. I take what the market gives me and move on. The concept of risk/reward in my mind does not apply to forex, I am a trader not an investor.
  • #11
  • Dec 7, 2007 5:19pm Dec 7, 2007 5:19pm
Risk/Reward ratio is calculated after a given # of trades. It's not somethign you decide before going into the market, otherwise you would be playing God. The idea that you can know how much your reward will be is nonsense. You are only in control of what you RISK, the prime force of MM. Risk is dependant on a number of variables which are unique to every trader: style, account balance, win % (if you know it), etc.

Go into a great setup for your system expecting a loss, and when you win (because your system is profitable in the long run) be happy. Don't decide beforehand how much you will make on that trade. A rough estimate is ok, but you will never be spot on (and most of the time not even close). Just know when to enter and how, and you will profit.
  • #12
  • Dec 7, 2007 5:25pm Dec 7, 2007 5:25pm
One should not be taking trades for no reason... hopefully trades are thought out in advance.... you have a reason for entering the trade, an idea of where it will go, and when to get out... you put your stop at the point where you know you are not willing to go any further with the trade or that at that point, things have changed and the trade idea is no longer valid... if you have put your stop in the right place and used correct MM, then you walk away from the computer with no worries... you either win, or you may lose and come back to trade another idea later...

Things happen and the direction of the market can change at anytime... it is not always that you made a mistake in your thinking about where things were going...

It is always good to try and find a point to get into a trade where you have to risk as little as possible... right now an example of this might be USD/JPY... there is a very good possibility that price would go down before getting 112... yet we are very close to 112 already... so I have gone short and my idea of where price would go is all the way to 109... NOW, it may happen that price continues up... BUT I will have my stop right above 112 and if I lose, I will only lose 40 pips or so, while I stand to gain a lot.... I also did not put so much on the trade, that it will hurt if I lose....
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  • #13
  • Dec 8, 2007 1:44am Dec 8, 2007 1:44am
Quoting Tiki Trader
One should not be taking trades for no reason... hopefully trades are thought out in advance.... you have a reason for entering the trade, an idea of where it will go, and when to get out... you put your stop at the point where you know you are not willing to go any further with the trade or that at that point, things have changed and the trade idea is no longer valid... if you have put your stop in the right place and used correct MM, then you walk away from the computer with no worries... you either win, or you may lose and come back to trade another idea later...

Things happen and the direction of the market can change at anytime... it is not always that you made a mistake in your thinking about where things were going...

It is always good to try and find a point to get into a trade where you have to risk as little as possible... right now an example of this might be USD/JPY... there is a very good possibility that price would go down before getting 112... yet we are very close to 112 already... so I have gone short and my idea of where price would go is all the way to 109... NOW, it may happen that price continues up... BUT I will have my stop right above 112 and if I lose, I will only lose 40 pips or so, while I stand to gain a lot.... I also did not put so much on the trade, that it will hurt if I lose....
Brilliant Brilliant Brilliant.....now that is what i like. I sooo totally agree with you. I think a lot of traders enter a trade just for the sake of it. Too many try and chase the market. But i love your approach.

Please educate me more while i ask a few questions.

So it would also make sense to enter a trade around S/R levels? That would also limit your risk say for example if you buy close to a support level. Chances are the support level will hold but if it gives away then you loose 20-40 pips. Or sell around a resistance level.

Or enter a trade at 38%, 50%, 61% fib levels?

Or how to you decide to enter?
  • #14
  • Dec 8, 2007 3:05am Dec 8, 2007 3:05am
i use a 50 pips S/L. When the trade i'm in is +50 pips i move the S/L to break-even. When i'm +100 pips i move the S/L to +50 and so on. however, i also close manually positions if i feel the trade will no longer be profitable and it has given me all it has to give
Twitter: @forexpokerpro
  • #15
  • Dec 8, 2007 3:50am Dec 8, 2007 3:50am
Ultra short term Daytrading = Ultra High risk/reward like 2:1 - 5:1
Short term trading Swing = High risk/reward like 1:1 - 1:3
Longterm trading Position = Low risk/reward like 1:10 - 1:20

If you can turn your risk/reward ratio to Position style and use this for Short term trading with profit in the end, then you are a damn good trader!
Trainee at UBS Investment Banking
  • #16
  • Dec 8, 2007 3:59am Dec 8, 2007 3:59am
Quoting Time
Brilliant Brilliant Brilliant.....now that is what i like. I sooo totally agree with you. I think a lot of traders enter a trade just for the sake of it.

He did. He was bullish up to 114+ just 12-24 hours before...now Tiki is making up a lot of reasons to excuse why he was swayed by talk instead of the chart and that he broke at least 2 cardinal rules at once (don't listen to others & no setup=no trade)
Trust price. Know yourself.
  • #17
  • Dec 8, 2007 5:04am Dec 8, 2007 5:04am
A long position at this area could also give a good RR ratio as a break of the head and shoulders that can be seen on your chart and the potential 400+ pips projection. We also have a Bullish engulfing bar/ Bullish outside bar on the weekly to give us a long bias possibly.

Quoting Tiki Trader
One should not be taking trades for no reason... hopefully trades are thought out in advance.... you have a reason for entering the trade, an idea of where it will go, and when to get out... you put your stop at the point where you know you are not willing to go any further with the trade or that at that point, things have changed and the trade idea is no longer valid... if you have put your stop in the right place and used correct MM, then you walk away from the computer with no worries... you either win, or you may lose and come back to trade another idea later...

Things happen and the direction of the market can change at anytime... it is not always that you made a mistake in your thinking about where things were going...

It is always good to try and find a point to get into a trade where you have to risk as little as possible... right now an example of this might be USD/JPY... there is a very good possibility that price would go down before getting 112... yet we are very close to 112 already... so I have gone short and my idea of where price would go is all the way to 109... NOW, it may happen that price continues up... BUT I will have my stop right above 112 and if I lose, I will only lose 40 pips or so, while I stand to gain a lot.... I also did not put so much on the trade, that it will hurt if I lose....
  • #18
  • Dec 8, 2007 5:04am Dec 8, 2007 5:04am
i ve read somewhere in the forum something called kellys formula derivation , according to it , when a trade has 1:2 R:R and a 50-50 win-lose chance , the risk taken should be of quarter (25%) of your capital on each trade , such combination would double your capital every 12 trades roughly
To Live is the rarest thing in the world , Most people exist , that is all
  • #19
  • Dec 8, 2007 7:24am Dec 8, 2007 7:24am
(1) On the risk management:

Yeah, use the ratio but equate EVERY risk to a fixed PERCENTAGE of your equity, and adjust it to market VOLATILITY. You want to fix percentage because that'll play your setup's edge more, and you want to normalize volatility because that'll also play your setup's edge more. Here's an example:

You spot a reversal, and put the stop atop the previous high, the stop is 30 pips (spread included so 25). You have $1000 and are trading mini-lots, so you must short only 1 mini-contract because the entire stop will be 3% of your equity. At the same time, do not fix stops to 20 or 30, or whatever. You need to increase the stop for more volatile markets like GBP and lower it for less volatile markets. Imagine putting a 30 pip stop on GBPJPY, you're MORE LIKELY to get stopped. But 30 pips on EURUSD is plausible.

(2) On the R distribution and expectancy:

The example given above is pretty good with the 2:1 ratio and 70% probability. But real systems get more complex than that, to get the R distribution chart and thus the expetancy I'll give you an example.

Let's say you are trading a setup where you can 1) get stopped out -1R, 2) break even 3) make 1R, 4) make 2R. (we're ignoring any other possibilities for the sake of explanation). What you need to do is calculate the number of trades that correspond to these options. So let's say you got stopped out 5 times, broke even 4 times, made 1Rs 3 times, and made 2Rs 2 times (you need to backtest and forward test much more than that).

Make a bar chart with the horizontal axis with "-1R, 0R, 1R, 2R" and then vertical axis is the number of trades. You calculate the expectancy by multiplying the number of trades by the R then summing them all up. So in this case, it would be -1 * 5 + 0 * 4 + 1 * 3 + 2 * 2 = 2R.

You finally need the "opportunity" which is the number of trades per time.
(R = your fixed percentage btw)

So what it boils down to is :

#trades/month * expetancy R/trade * fixed percentage%/R = %/month


You can reverse this by having a goal (X % /month) and then giving it a fixed percentage.

The position sizing equation is :
(1+ expectancy * fixed percentage)^opportunity = goal

Example:
(1 + 2R * X) ^ 10trade/month = 1.2 (20% per month)
(1 + 2R * X) = 1.2 ^ (1/10)
(2R * X = 1.2^0.1 - 1
X = (1.2^0.1 - 1)/2

And you should get a fixed percentage number. Of course, there's variance so this is a ballpark measure. What does this equation tell you about position sizing?

For a fixed goal, the better your edge (higher expectancy) the lower you can risk and thus have a smoother, non-volatile equity curve. But if your edge sux, then you need to risk higher, and anything above 3% is just too crazy in my opinion, so if you want to be 40% a month and this equation is telling you that you need to risk 5%, you need to find a way to improve your edge.

(3) On reward to risk ratio:

The guy above me did a good job of basically classifying the ratios for scalpers, swing trades, and position traders. But what you can also do is something called "stalk the market" which is the zoom in on the reversal level and then use price action or other triggers to enter. Why stalk the market?

I mentioned fixing ALL your trades to a fixed percentage. This is important. Here's why.

Imagine you're about to setup a trade with 100 pips potential gain (ignore spread). If you enter on a large timeframe and your stop is 50pips, and that equals 3% of your equity, your potential gain is 6% for a 2:1 r^3 (from now on, I will call the risk:reward ratio r^3 (pronounced r cubed)).

But let's say you stalked the market and you further analyzed the situation and said, "Hmm there's an important confluence level here" and set up an order there with 25pips. Again since that should equal 3%, your potential gain is 12% for a 4:1 trade.

Let's say you're extremely good and experienced and put up a 10pip stop. Your r^3 has now become 10, for a potential 30% trade.

See how the potential PIPS doesn't really matter? This is how you NEED to use risk management/position sizing.

You might ask, "How the spread play a role in killing you?" We'll get to that in a minute but there're few very important things to note here:

a. What does using a tighter stop mean? It means two things: higher potential reward, but a higher probability of getting stopped out. Wait, but doesn't getting stopped out mean a bad thing? Yes and No. If you get stopped out a few times but get that huge winner, your risk is JUSTIFIED. But how do you know whether you will get stopped out more frequently to get a negative edge? For example, if you are trading 10R trades, you can basically get stopped out 10 times and get a winner to BREAK EVEN. Anything more than 10 means a negative edge. (-1 * 10 + 10 * 1 = 0)

b. Tighter stops (let's say you get a higher edge than if you were to trade with medium stops) also mean that since you'll be getting stopped out more frequently that your equity curve will be much more CHOPPIER than regular.

c. Tighter stops give you more potential gain if you are very good, but it also taxes your PSYCHOLOGY the most - the hidden cost. This is why not everyone can do this, because it's very hard psychology. Not too many people can trade 3% per trade and get a losing streak and continue the same position sizing. It is the fear that prevents the trader from risking the same that decreases that winner so that the overall edge becomes negative.


By stalking you can take your regular 3:1 trade to a 7:1 trade, but here's a word of advise if you do. The lower timeframes are noisier, meaning you should wait until there's a very good entry, and you should expect multiple losses so don't worry about getting stopped out once: wait for a re-entry.



Anyway, hope this kind of helped. If you need ANY clarification, feel free to ask.
  • #20
  • Dec 8, 2007 7:30am Dec 8, 2007 7:30am
Here's why not too many scalpers make a good living.


Let's say you're in a trade with a 10 pip stop (15 in actually because of spread, assume spread is 5 pips for all trades) and you want a 3:1 trade. Because the stop is 15, you need 45 pips in profit, but because of the spread, the market has to actually move 50 pips.

You see how, just to get a 3:1 trade, the market has to move 50 pips compared to 10 pips to stop you out?

This is what the spread does, it kills your edge! The market movement ratio (mmr, from now on) is 5:1 but your gain is 3:1! That's pretty tough.


But let's say you're swing trading and your stop is 45 pips(50 total) and gain is 195(200 total).
Your gain is a little less 4:1 and the mmr is also 4:1. The spread has become negligible.

The higher the timeframe the less important the spread effect has on your edge.



Here's a little something for your to remember about the spread:
For X pips for stop, you need to ADD THE SPREAD.
For Y pips for target, you need to SUBTRACT THE SPREAD.
This applies to both shorts and long.

So you want a 10 pip stop, you need 15.
So you want a 50 pip target, if the market moves 50 pips, you actually get 45.
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