For those new traders reading this, a reward to risk ratio is the amount of profit we expect to take in a trade vs. the amount of risk or loss we are willing to take. I might be willing to take a trade with a $500 profit target, while risking $100. This would be a 5:1 reward to risk ratio. Whenever I hear someone say they take a 1:1 reward to risk on a trade, especially someone who is not as profitable as they would like to be, my question is always, “How often do you have to make money on your trades to make a decent living?” The easy math is, “At least 50%.” However, this low number really means you are barely over break even. To make “real” money, your ratio probably needs to be closer to 80%. When you factor in the occasional slippage/bad fill, your ratio might even need to be closer to 90%. Even very experienced, highly profitable traders have a hard time achieving this number!
Back to the topic at hand. By using core strategy of buying in quality demand zones and selling in quality supply zones, we can normally achieve a much better reward to risk ratio than the standard trading techniques taught out there on the internet or in trading books.
Many trading techniques out there tell you to enter a trade AFTER IT IS ALREADY GOING YOUR DIRECTION. Often this would be considered a “breakout” buy or a “breakdown” short. In the following chart, the blue arrows indicate where a potential long trade could have been placed, with the corresponding profit target. In this example, an entry to buy could have been taken at 1.1140 with a profit target at 1.1260 and a stop loss at 1.1100 for a reward to risk ratio of 120:30, or a 4:1.
A breakout long entry might have been placed at the purple line, where the price action broke past the previous swing high at approximately 1.1205. Your target would have been near the 1.1260 level, BUT YOUR STOP WOULD STILL NEED TO BE AT 1.1100. This would have given you a reward to risk ratio of 55:105, or almost a 1:2! This is backwards; I’ve never met a consistently profitable trader who could pull this off over time! The interesting part of this is that trading is the only place on the planet where people buy things after they get expensive and sell them after they get cheap! When you go to the store looking to buy a new shirt and you know that the shirt is normally $50, do you wait until the price is marked UP to $100 to buy it? Of course not! Most people I know wait until the price is marked DOWN to buy. What is the purpose of a store having a largely advertised sale? To inspire increased demand! Price goes down, demand goes up. You should apply the same methodology to your trading; when price goes down, I’m looking to buy cheap. When price goes up, I’m looking to sell expensive, which, you may have heard, is how successful businesses are run.
On the chart, I also marked in a much higher supply zone. At that level, you may have taken off another portion of your trade if you prefer to “scale out” of your position. If this was your final target for your entire position, your reward to risk ratio would have been 215:30, or about 7:1. Not too bad!
Now, I intentionally showed the price action that continued past my two supply zones. This was to illustrate the fact that we never KNOW where price will completely reverse direction; selling the absolute high point is only done by two traders; the lucky (and it probably won’t happen again) and the liars. The sooner you can accept the fact that buying absolute lows and selling absolute highs is impossible, the better off you will be. I’ve met too many traders in my career who have tried that and failed, kicking themselves every time they miss those last few pips. I would rather spend my time looking for the next good trade than wishing I had made just a few more pips on the last one!
So there you have it. By using our core strategy, you will trade more like a successful business: buying cheap and selling expensive, also increasing your reward to risk ratio! As the unsuccessful traders “chase” the prices higher, you will be sitting back and enjoying the ride!
Wriiten by Rick Wright, Online Academy Trading Instructor. Rick Wright’s goal as an Online Trading Academy Instructor is to accelerate the student’s learning curve, whether they are interested in High Frequency Trading or Investing for Beginners. He teaches classes on Online Stock Trading, Forex Trading and Futures, among others. Rick studied economics and psychology at Iowa State University, and entered into the brokerage business in 1992. He earned the NASD Series 4,7,9,10,24,55,63, and 65 licenses. He helped grow an online brokerage business which was eventually sold off. Rick has also held positions as broker, branch manager, and several VP positions in the brokerage business. Rick began trading equities in 1997, and was introduced to the Forex market in 2002. Currently trading from home in Dallas, Rick is also a frequent contributor to various TV and business talk radio shows.