In Price Action Trading Strategy

A newer trader is likely to overlook or disregard many discussions on risk/reward because they are either busy fantasizing about millions in profits or too inexperienced to understand the importance of maintaining a proper risk/reward ratio. It is completely possible to have a system that wins 99% of the time, with the other 1% wiping out an entire account if not properly managed. It is also possible to have a system that loses 99% of the time, with the other 1% maintaining a net profit.

For myself, everything begins with risk/reward. One of the first questions I ask before considering any trade is “Is the trade in the boundaries of my risk/reward ratio?” If it’s not, I immediately pass and stop wasting any more of my time. If it doesn’t fit my risk/reward criteria, I’m not interested.

Risk/reward ratio refers to the amount a trader is willing to risk versus his or her expected reward.

If your risk/reward is 1:3, you only need to win 3 out of 10 trades to turn a profit (eg risk losing 50 pips to gain 150 per trade).

For example, lets assume 10 trades with a 60 pip take profit, with a -20 pip stop loss and trading 5 contracts where 7 were losers and 3 were winners (risk/reward 1:3)

60 * 3 = 180 pips * 5 contracts = $9,000
-20 * 7 = -140 pips * 5 contracts = $-7,000
Net them out and you have a profit of $2,000

This higher your risk/reward ratio, the better. Without proper usage of risk/reward, consistency over time is extremely difficult if not downright impossible. If the math doesn’t work out, the profits simply won’t be there.

So what’s a good risk/reward ratio to use? It depends on your system and historic performance. If your win rate is better than 50% at a static risk/reward ratio, then slightly better than 1:1 is all you need to turn a profit. If your win rate is only slightly better than 30% at a static risk/reward ratio, then 1:3 is required to turn a profit.

I see little point in seeking any less than 1:3 risk/reward on all of my trades, though this is not necessarily always the case. Even though my win rate is better than 50%, by maintaining a strict risk/reward profile I am able to enhance my performance, and weed out any potentially weak-performing trades. For myself, it is a matter of discipline. 1:3 is my ‘benchmark’, but there are times when its necessary to adjust this for better bottom-line performance.

Ultimately, your risk/reward ratio should never drop below a certain level based on the historical performance of your trades. When starting off and without a good history of trades by which to measure, it is a good practice to prepare for the worst and assume at least 1:3. Once you begin to build a history of trading activity you will be better able to apply a more dynamic ratio to your routine.

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Showing 2 comments
  • seattlerust
    Reply

    Hi Steve,

    I’ve bee trading various markets for a long time and this issue of risk vs reward has interested me for many years. I thought I would toss out a few issues that have occurred to me over time and get your take on them.

    Don’t misunderstand me, I fully agree that this issue must be high in the hierarchy of consideration for placing a trade. As your arithmetic shows, understanding what the necessary probable reward for a given risk is key to being profitable. And since we have no true control over profit, we must take control over risk, which in reality is the only thing that we can control.

    So here are a few issues, in no particular order, that I think must be considered beyond the discussion that you presented.

    (1) Knowledge, experience and confidence are important in understanding the market being traded. Beyond that, IMO, methods of determining potential profit is “iffy”. Usually there are all those pesky support and resistance levels in the way and sometimes we have to overcome them one by one to achieve the eventual target. So, how do you set the Reward to use for the calculation of the R/R ratio? And this leads me into the second, but related issue—-
    (2) Most traders following this thread will scale out of a trade; usually by taking some percentage of the trade off as the first significant support or resistance level is neared. Usually, this is accompanied by a move of the Stop to some form of break-even or perhaps profit protection. So, how does this affect the arithmetic? Does the R/R apply only to the first profit level? I.E. the first encountered S/R level? Or the ultimate potential profit level, perhaps at some Fib extension or trend line or range boundary?
    (3) In some trades, probably mostly position trades, we can expect some significant swings over time. If our projected profit is a fair distance away, to allow those swings to not stop us out of the trade, requires some large risk. This probably only applies to a small part of the original trade, given that partial profits have been extracted. But still, the R/R of this remainder needs to be accounted for in the overall scheme of things because it sometimes produces a significant portion of the trades profit, even though it contains a small percentage of the original lots.
    (4) How might one “modify” the proper R/R based on the probability of success in a given trade? For instance, I once traded an option strategy that had a very high probability of success. I actually made over 50 trades before I had my first loss (let me tell you it scared me to death, too, even though I had done a huge amount of paper trading before placing real money in this). Anyway, the risk was significantly greater than the reward. Is this even worthy of consideration? There are traders out here (so the rumors go) who do have a fantastically high success record. Should they modify their ratios accordingly?

    I think there are other issues but these are enough to go with. I am really interested in your thoughts. As everything in trading, it is not rocket science; but it sure isn’t easy.

    Thanks for all that you do.

    Sincerely,
    Seattlerust

  • Anonymous
    Reply

    I just would like to mention that adjusting risk/reward affects win rate and vice versa. These factors depend on each other and should be optimized paralelly.

    Best regards

    Konrad

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