The risk/reward ratio

"1,4721. EUR USD is in a range between 1,4580 and 1,4760. EUR USD moves without trend and swings around exponential moving averages (EMA 50 and 100). The volatility is high. Bollinger bands are flat. ForexTrend 4H, daily is in a bullish configuration. 4H ForexStoch indicate a bullish pressure on EUR USD. The price should find a resistance below 1,4760. The consolidation should continue. We won't take a position. The risk/reward ratio is too high to take a position.."

hi...

I'm a newbie, i read the above quote but couldn't understand on 'the risk/rewards is too high'..
What does it means..
Why they didn't take a position, is it because of moves or bollinger bands or other consideration..

Hi Aothman

A trader decides at what price he would like to enter a trade. Then he sets a stoploss, which is an arbitrary price at which he will exit the trade on the basis that price is moving unfavorably, at which point he wants to cut his losses. The difference between these two, and hence the number of pips that would be lost, is the RISK. Many traders place their stoploss just outside the most recent significant ("swing") high (for a short trade) or low (for a long trade). [The position size, i.e. number of lots traded, determines the number of dollars won or lost per pip moved. Thus this value may be multiplied by the number of pips risked to convert the risk to absolute dollars].

The trader might then estimate about how far he expects the trade to move favorably, i.e. set a profit target. The number of pips between this profit target and the entry is the estimated RETURN or REWARD. This estimate is often based on the nearest area of significant support or resistance. Just like the risk, the reward can also be converted to absolute dollar terms, if desired.

The reward divided by the risk gives the reward-to-risk ratio (also called "RR", "RRR", "R value" or "win size").
If RR > 1, then Reward > Risk
If RR < 1, then Risk > Reward

Some traders want to see RR significantly greater than 1, before they will take a trade. This is in keeping with the maxims "cut losses short" (low risk), and "let profits run" (high reward). This is especially true of "trend traders", i.e. those who are seeking to let profits run across long trends.

However, IMHO, a high RR value is not necessarily beneficial, because it tends to operate in inverse proportion to win rate. In other words, if the stoploss ("SL") is a lot closer to the entry point than the profit target ("TP"), then – everything else being equal – price is more likely to reach the SL before the TP. Hence the probability of making a winning trade is reduced, and over several trades this will lower win rate. It's especially frustrating to see a trade that would have eventually become a winner get "prematurely" stopped out. But that is one of the occupational hazards of trading.

Profit factor ("PF"), also called expectancy ("EV"), is the product of win rate and RR. IMHO this gives an accurate and objective measure of the effectiveness of a system of entries and exits.

EV can also be calculated as = ( number of wins x average net win ) / (number of losses x average net loss )
which is also the same as = dollars won / dollars lost

If EV > 1, then the system has positive expectancy, or winning edge. Statistically it will make money, over a large number of trades.

If EV < 1, then the system has negative expectancy. Statistically it will lose money.

Many trend traders are happy with a win rate of 30%–40%, because they are looking for trades where RR > 2 or even RR > 3. For example, if a system has a win rate of 40% and an RR = 2, then the EV = (0.4 x 2) / (0.6 x 1) = 1.333, i.e. a positive expectancy system, despite a win rate < 50%.

[NOTE: In the example you quoted, it looks like the trader has divided risk by reward, instead of the other way around, hence he is seeking a low risk-reward ratio.]

Hope all of this makes sense.

David

[Edit: I added the graphic below. I'm not suggesting that this is necessarily a profitable way to trade, just using it to illustrate RR calculation]

Some more of my thoughts on RR here: http://www.forexfactory.com/showthread.php?p=1764742
for whatever they might be worth.

David

Hi David..

Your detail explanation is very much appreciated..
Thanks a lot..

David:

Thanks for the info.