The 2/1 risk/reward MYTH... | Forex Factory

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The 2/1 risk/reward MYTH...

  • #1
  • First Post: Feb 28, 2007 10:14am Feb 28, 2007 10:14am
I have noticed that some forex traders here at the forexfactory naively believe that the best and only way to make money in the forex market is to trade with a 2/1 risk/reward or better, meaning that for every dollar that you risk on each trade you get back two or more.

This is of course a myth and here is why:

A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is "only" $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.

But does it mean you will get filthy rich because this is a good risk/reward bet? Of course not! In fact keep playing that way long enough and you will end up in the poor house sooner or later, because of the casino's built-in mathematical advantage. This is by the way the SAME mathematical advantage that every forex broker possesses on each trade (bet) you are initiating, because of the 3 to 5 pip spread. That's why most forex traders (like casino players) end up losing their money in the long run, even if they are right about the direction of the market 50% of the time!

So in conclusion it does NOT matter if you are trading with a 2/1 or 2000/1 risk/reward, the ONLY WAY to make money in the forex (or futures, stocks, etc...) is to have a STATISTICAL EDGE.

In other words your entry and exit points must BEAT pure random entry/exit points.
  • #2
  • Feb 28, 2007 10:28am Feb 28, 2007 10:28am
The way that I've always understood it presented is that the risk/reward ratio is important in conjunction with your winning percentage. You can't build a good system without taking both into account.
  • #3
  • Feb 28, 2007 10:39am Feb 28, 2007 10:39am
In my opinion when you trade, you don't trade agains your broker(like in a casino),the broker is an intermediator, and the spread is theyr winning(profit you can say). Brokers don;t wan't you to lose money, they wan't to have a big number of transactions, so they can take profit from the spread. Forex traders don't loose money agains brookers(like a casino player in a casino), they loose it against other traders.
I'm wrong or I didn't understand what you were saying?
"Abandon all hope, you who enter here" La Divina Commedia, Dante Alighieri
  • #4
  • Feb 28, 2007 10:39am Feb 28, 2007 10:39am
Quoting FXTerminator
I have noticed that some forex traders here at the forexfactory naively believe that the best and only way to make money in the forex market is to trade with a 2/1 risk/reward or better, meaning that for every dollar that you risk on each trade you get back two or more.

This is of course a myth and here is why:

A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is "only" $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.

But does it mean you will get filthy rich because this is a good risk/reward bet? Of course not! In fact keep playing that way long enough and you will end up in the poor house sooner or later, because of the casino's built-in mathematical advantage. This is by the way the SAME mathematical advantage that every forex broker possesses on each trade (bet) you are initiating, because of the 3 to 5 pip spread. That's why most forex traders (like casino players) end up losing their money in the long run, even if they are right about the direction of the market 50% of the time!

So in conclusion it does NOT matter if you are trading with a 2/1 or 2000/1 risk/reward, the ONLY WAY to make money in the forex (or futures, stocks, etc...) is to have a STATISTICAL EDGE.

In other words your entry and exit points must BEAT pure random entry/exit points.

Your confusing random entry with applying an edge to better than average opportunities. What is meant by this is that you find your edge and then apply it to the best opportunities in the market, meaning opporunities yielding more than a 1:1 risk to reward. If you have an edge that gives you a 40% probability of being right, don't you think it would be important to have better than a 1:1 on that trade? If your system has a 70% probability of being right then you might not hold as much merit to the higher than 1:1 rule. Make sense?
  • #5
  • Feb 28, 2007 10:47am Feb 28, 2007 10:47am
FXT,

You make a good point, but your logic is flawed.

Risk Reward goes hand in hand with expectancy. This is the part that you're leaving out. 35/1 does you no good if your expectancy is 1/37 (as it is in a double-zero roulette wheel)...your COMBINED RR is less than 1. So this is an invalid point because your expectancy much lower.

With a 2/1 RR, you need to have a an expectancy greater than 1/3 in order to be profitable (you need to win once for every 2 losses to break even).

SO...don't confuse the mathematics here. RR is very important but you absolutely need to know your most common expactancy (which may be difficult to figure out because expactancy is affected by random factors). This why the game is difficult, because the random nature of the world (let alone the market you are analyzing) can give you all the data in the world, but your expactancy can still be less than you'd hope.

Quoting FXTerminator
I have noticed that some forex traders here at the forexfactory naively believe that the best and only way to make money in the forex market is to trade with a 2/1 risk/reward or better, meaning that for every dollar that you risk on each trade you get back two or more.

This is of course a myth and here is why:

A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is "only" $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.

But does it mean you will get filthy rich because this is a good risk/reward bet? Of course not! In fact keep playing that way long enough and you will end up in the poor house sooner or later, because of the casino's built-in mathematical advantage. This is by the way the SAME mathematical advantage that every forex broker possesses on each trade (bet) you are initiating, because of the 3 to 5 pip spread. That's why most forex traders (like casino players) end up losing their money in the long run, even if they are right about the direction of the market 50% of the time!

So in conclusion it does NOT matter if you are trading with a 2/1 or 2000/1 risk/reward, the ONLY WAY to make money in the forex (or futures, stocks, etc...) is to have a STATISTICAL EDGE.

In other words your entry and exit points must BEAT pure random entry/exit points.
  • #6
  • Feb 28, 2007 11:07am Feb 28, 2007 11:07am
dismissing the 1/2 risk reward ratio is definitely a flawed argument. Trading in forex is very different than playing roulette or playing lotto. The chances of winning is very small with gambling.

But in the financial markets, even though nobody can predict the market, you have enough edge from fundamental and technical analysis to get you on the winning side given that you follow a certain method with consistency. And the fact that each trade is a uniqe opportunity, you haveto make sure you will be statistically ahead by getting the most rewards with your initial risk on each trade.

Because of this I believe that trades that only uses reward to risk of less than 2, could potentialy lead you to ruin or breakeven in the long term. You have to have a system that is consistently 60-70% winning percentage to take advantae of 1 to 1 risk to reward ratio. And from what I read in Van Tharp and other books, most successful traders make money from less than half of their trades (<50%).
  • #7
  • Feb 28, 2007 11:11am Feb 28, 2007 11:11am
Quoting mrmikal
FXT,

Risk Reward goes hand in hand with expectancy. This is the part that you're leaving out. 35/1 does you no good if your expectancy is 1/37 (as it is in a double-zero roulette wheel)...your COMBINED RR is less than 1. So this is an invalid point because your expectancy much lower.
You are of course absolutely right, you and other members before you in this thread: Risk/reward ratio and winning percentage (and/or mathematical expectancy if you prefer) are always related.

But that's precisely what I was saying and nothing else!

Let me clarify with an example. If you decide to trade with a 2/1 RR (Risk/Reward) ratio, your winning percentage MUST mathematically be greater than 33% if you want to make money. A 3/1 RR ratio needs more than 25% winning percentage and so forth.

But again, like I was saying, this RR ratio does NOT matter at all. You could do the reverse, for example you could risk 100 pips on a trade just to make 10 pips and still end up making tons of money in the long run if your winning percentage is high enough.

In other words your entry/exit points must simply beat random entry/exit points, regardless of your RR ratio or winning percentage.
  • #8
  • Feb 28, 2007 11:23am Feb 28, 2007 11:23am
Quoting FXTerminator
You are of course absolutely right, you and other members before you in this thread: Risk/reward ratio and winning percentage (and/or mathematical expectancy if you prefer) are always related.

But that's precisely what I was saying and nothing else!

Let me clarify with an example. If you decide to trade with a 2/1 RR (Risk/Reward) ratio, your winning percentage MUST mathematically be greater than 33% if you want to make money. A 3/1 RR ratio needs more than 25% winning percentage and so forth.

But again, like I was saying, this RR ratio does NOT matter at all. You could do the reverse, for example you could risk 100 pips on a trade just to make 10 pips and still end up making tons of money in the long run if your winning percentage is high enough.

In other words your entry/exit points must simply beat random entry/exit points, regardless of your RR ratio or winning percentage.
So what is your point? It matters when it matters but not when it doesn't? I guess I'm missing the "lesson".
  • #9
  • Feb 28, 2007 11:30am Feb 28, 2007 11:30am
Quoting hilmy83

Because of this I believe that trades that only uses reward to risk of less than 2, could potentialy lead you to ruin or breakeven in the long term.
Again, this is a myth my friend, a myth with no mathematical justification whatsoever.

Quoting hilmy83
You have to have a system that is consistently 60-70% winning percentage to take advantae of 1 to 1 risk to reward ratio.
No, you could have a system that is winning 0.1% of the time and still make millions if your entry/exit points consistently give you a definitive statistical edge.
  • #10
  • Feb 28, 2007 11:36am Feb 28, 2007 11:36am
Quoting hidethereal
So what is your point? It matters when it matters but not when it doesn't? I guess I'm missing the "lesson".
The point is this : do NOT trade simply because you like the Risk/Reward ratio, the risk/ratio by itself is totally meaningless, trade because your entry/exit points give you a mathematical edge.

Of course this mathematical edge itself can only be discovered through testing, but that's another story.
  • #11
  • Feb 28, 2007 11:47am Feb 28, 2007 11:47am
Quoting FXTerminator
The point is this : do NOT trade simply because you like the Risk/Reward ratio, the risk/ratio by itself is totally meaningless, trade because your entry/exit points give you a mathematical edge.

Of course this mathematical edge itself can only be discovered through testing, but that's another story.
And if your mathmatical edge requires that you have a better than 1:1 risk to reward? Then what?

What about a 30% edge? Like trend following systems. Do we just throw these out the window despite their profitability because you feel that risk to reward is unimportant?
  • #12
  • Edited 12:13pm Feb 28, 2007 12:03pm | Edited 12:13pm
Quoting hidethereal
And if your mathmatical edge requires that you have a better than 1:1 risk to reward? Then what?
Then take the trade my friend, where is the problem ??

Quoting hidethereal
What about a 30% edge? Like trend following systems. Do we just throw these out the window despite their profitability because you feel that risk to reward is unimportant?
Did I say that ? Where ?

Here is another idea to meditate on :
Take a specific hour of the day, let's say 9AM EST. Then flip a coin and if it comes up Tail bet that the GBP/USD will go up 60 pips by the end of the day unless you are stopped by a 20 pip loss. Do the reverse (sell) if it's Head .

So we have a 3/1 risk/reward situation here, are you with me so far ?

Ok, do this a a thousand times (days) and you will notice that you are consistently losing money (because of the spread), even though the risk/reward ratio is good.

Get it now, fellow forex trader ? http://forexfactory.com/images/icons/icon6.gif
  • #13
  • Feb 28, 2007 12:17pm Feb 28, 2007 12:17pm
Quoting FXTerminator
Then take the trade my friend, where is the problem ??



Did I say that ? Where ?

Here is another idea to meditate on :
Take a specific hour of the day, let's say 9AM EST. Then flip a coin and if it comes up Tail bet that the GBP/USD will go up 60 pips by the end of the day unless you are stopped by a 20 pip loss. Do the reverse (sell) if it's Head .

So we have a 3/1 risk/reward situation here, are you with me so far ?

Ok, do this a a thousand times (days) and you will notice that you are consistently losing money (because of the spread), even though the risk/reward ratio is good.

Get it now, fellow forex trader ? http://forexfactory.com/images/icons/icon6.gif
Can you show me where it has ever been written to base a trade solely on risk/reward? I think your own misinterpretation of the material you were reading has lead you to this pointless conclusion.
  • #14
  • Edited 1:28pm Feb 28, 2007 12:46pm | Edited 1:28pm
Quoting hidethereal
Can you show me where it has ever been written to base a trade solely on risk/reward? I think your own misinterpretation of the material you were reading has lead you to this pointless conclusion.
Not at all, I started this thread because too many traders (newbies or amateurs) on this forex forum and other forums worldwide assume that if they lose less on a trade (compared to what they could make) they are trading the right way.

Here is a typical dialogue between these traders during a chat session :

"Hi, what are you trading today ?"

"I just shorted the Yen, I have a hunch (??), my risk is only 15 pips and my take profit is set at 60 pips"

"Oh, nice, then even if you lose that's not a big deal, you only need to win once to recoup all your losses"

Well that is NOT Ok and it IS a big deal, trading only because the Risk/Reward ratio is good (and only because of that) is never a good thing to do.

That's the message I was trying to deliver today.

That said back to the FX Trading Station, I have to close a (profitable) euro position. http://www.forexfactory.com/images/icons/icon7.gif
  • #15
  • Feb 28, 2007 12:55pm Feb 28, 2007 12:55pm
FXT,

I see what you're saying...but I think others may not understand.

Basically, folks, what he's saying that having a Risk Reward is pointless unless you have a system that provides you a proper winning percentage.

What FXT is saying IS correct, there IS a myth that having a Risk/Reward ratio of 2/1 is necessary.

What FXT is not explaining correctly (in my opinion, no offense, FXT) is that more important that RR is your expectancy (win ratio). You must use your win ratio to calculate your required RR...which is absolutely the case.

Having a 2/1 RR is just some arbitrary number that a lot of traders stick by for whatever reason.

The issue that I have with the examples is that they don't properly explain how to calculate your true RR based on your expactancy.

In the example of the heads or tails flip with a 60 to 20 gain on the GBPUSD, what is implied is that there is a 50% chance of calling long or short, but this isn't the expactancy of the system...the expectancy of the system is based on how often a trade hits 20 pips in the red before it hits the TP. In a vacuum (random chance), you'd expect that chance of the price going up versus going down at a point would be 50%...however, that's not what we're calculating...we're calculating the chance of avoiding a 20 pip SL versus a 60 pip TP...those chances cannot be quantified (because if they could, you'd be rich).

Let's put it a different way...

Why is it the case that if we are absolutely sure that you'd lose money with a 3/1 RR and horrible expectancy that you couldn't simply invert the direction of the trade and win?

Think about it...if we're absolutely sure that if we were to flip a coin and then bet in the direction of the flip with a SL of 20 and a TP of 60 that we'd lose money...why wouldn't you bet in the opposite direction of the flip with a 20 TP and a 60 SL?

If the other side is a loser then the inverse has to be true, right?

Well the reason that neither system works is because the expectancy of the first system cannot be quantified properly. Therefore neither system's expectancy can be quantified...

That's why TP and SL aren't your true measurement of Risk Reward.


Quoting FXTerminator
Then take the trade my friend, where is the problem ??



Did I say that ? Where ?

Here is another idea to meditate on :
Take a specific hour of the day, let's say 9AM EST. Then flip a coin and if it comes up Tail bet that the GBP/USD will go up 60 pips by the end of the day unless you are stopped by a 20 pip loss. Do the reverse (sell) if it's Head .

So we have a 3/1 risk/reward situation here, are you with me so far ?

Ok, do this a a thousand times (days) and you will notice that you are consistently losing money (because of the spread), even though the risk/reward ratio is good.

Get it now, fellow forex trader ? http://forexfactory.com/images/icons/icon6.gif
  • #16
  • Feb 28, 2007 1:02pm Feb 28, 2007 1:02pm
I love your post. Halfway through I was going to point out, at a roulette it's still random, versus here you can at least have a lot of reason to believe something is going to happen the way you think.
And then you mention statistics.

I have lost a trade due to spread once. Played an AUD/USD news release. Was right in the direction, wrong with the spread. I sit out a lot of scalps and such because I'm afraid I won't cover the spread.
In stocks if you want more money with less movement and not worry about commissions, you wager more. In forex that spread is always fixed. Wonder if it restricts retail volume.

Quoting hilmy83
Because of this I believe that trades that only uses reward to risk of less than 2, could potentialy lead you to ruin or breakeven in the long term. You have to have a system that is consistently 60-70% winning percentage to take advantae of 1 to 1 risk to reward ratio. And from what I read in Van Tharp and other books, most successful traders make money from less than half of their trades (<50%).
Which goes to my favorite, or maybe only trading slogan I go by. Smaller loses bigger gains.
  • #17
  • Feb 28, 2007 1:17pm Feb 28, 2007 1:17pm
risk reward ?????
yes it is important but the headake is always stops, so how i trade now is pure risk based on daily close so the risk is 1 thing i cannot calculate but i trade with money management on the winning trades and add to them as well.when i add to my trades i add smaller than the first and so on in this way i stay in focus on the trades in profit 1 of my favorites is buy take profit on half let other run and then add a stop at breakeven. but no matter what it is important to find that method that works for 1 and then keep going in that way. Many might think im nuts trading without stops probably yes but it works for me and yes i have taken some big losses;-)

revoke
  • #18
  • Edited 2:00pm Feb 28, 2007 1:51pm | Edited 2:00pm
a simple formula for your expected payoff:

Payoff = Sum(Probability(i) * Payoff(i)) where i is a given outcome.

Example:

RR is 2/1
Win% is 60% = 0.6

Lets decompose the RR so that a win is equal to a payoff of 2, loss is payoff of -1.

Payoff = WinAmount*Win% + LossAmount*(1-Win%)
Payoff = 2*0.6 + (-1)*(1-0.6)
Payoff = 1.2 + (-0.4)
Payoff = 0.8

As you repeat this over and over again your payoff will approach 0.8 because of "The Law of Large Numbers"

That should be pretty self-explanatory.


Additional helpful stuff:

Chance of having x losses in a row is (1-Win%)^x.
Ex: 4 losses in a row with these numbers.
(1-0.6)^4 = 0.4^4 = .0256 = 2.56%

If you want to find out how many losses in a row you can sustain with y dollars and chance it will happen. Losses equal floor(y/LossAmount). Floor just means the integer below the decimal since you can't have half a loss for this exercise. Then do the x losses in a row step.
Ex: y = $1000, Loss Amount = 110, Win% = 0.6
floor(1000/1.1) = floor(9.0909) = 9
(1-0.6)^9 = 0.4^9 = 0.000262 = 0.0262% of all $1000 gone
  • #19
  • Feb 28, 2007 5:29pm Feb 28, 2007 5:29pm
Quoting flareup
Chance of having x losses in a row is (1-Win%)^x.
Ex: 4 losses in a row with these numbers.
(1-0.6)^4 = 0.4^4 = .0256 = 2.56%
This is true ONLY if you assume that the outcome of each trade is random and not related in any way to the outcome (win/loss) of the preceding trade.

I strongly believe that any system with a positive mathematical expectancy (a backtested and profitable forex system in our case) does NOT generate trades with random outcomes.

In other words, as you lose while trading, you chances of winning the next trade increase !

Yes I know, a lot of mathematicians in this forum are going to jump to the ceiling and shout : "What the hell is he talking about!!!!!!" http://www.forexfactory.com/images/icons/icon10.gif
  • #20
  • Feb 28, 2007 5:51pm Feb 28, 2007 5:51pm
Quoting semar
In my opinion when you trade, you don't trade agains your broker(like in a casino),the broker is an intermediator, and the spread is theyr winning(profit you can say).
In a Walt Disney movie perhaps, but in real life some (repeat SOME) forex brokers won't hesitate to bet against you, taking not only the spread but your position as well.

Don't forget that your friendly FX broker has always an (almost unfair) advantage: he can see the "fair" price of a currency pair instantly and adjust his position accordingly, you cannot.
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