Setting Your Risk-Reward Ratio
It is reasonable and a good idea to set up a risk to reward ratio for each trade that you enter. Knowing ahead of time how much you stand to gain versus how much you stand to lose is something that could serve you very well when you start trading more frequently.
A risk/reward ratio of at least 1:2 is recommended for all trades. This means that you stand to gain two dollars for every dollar you put at risk. This two-to-one payout is ideal because you want to make sure your winners more than take care of your losing trades.
Some people hike their risk/reward ratio even higher to make sure they gain as much as possible when they trade correctly.
Even at a 1:2 ratio you would only need to be right 33.33% of the time to theoretically break even. That is a nice place to be as a trader. You can be wrong more often than you are right and still come out on top if you just get your trading ratios lined up properly.
Focus on your win rate and how often you believe is reasonable for you to be on the winning side of trades. If you feel that your rate is lower than you would like, then you might want to set up a risk/reward ratio that allows you to win at a lower rate and still come out ahead.
Just be prepared for the fact that doing so means that fewer of your trades will turn up as winners. You need to be prepared to embrace the harsh reality of this from a psychological point of view. You cannot afford to get too down about losing many trades in a row if you set them up this way.
Always Compare Win-Rate and Risk-Reward Together
Diving a little deeper into your win-rate and the reward: risk ratio that you have set up, you should try to think about the two factors together. They go together because your win rate and the amount of risk versus reward that you set up with each trade will ultimately determine if you are a profitable trader or not.
Breaking this down into some examples may prove useful.
Trader A
- Trader A sets up a risk/reward ratio of 1:2
- Trader A has a win rate of 40% over 100 trades
- Trader A risks $100 per trade
- Trader A profits’ $2,000 over the course of those trades ($8,000 in winning trades minus $6,000 in losing trades)
Trader B
- Trader B sets up a risk/reward ratio of 1:3
- Trader B has a win rate of 20% over 100 trades
- Trader B risks $100 per trade
- Trader B loses $2,000 over the course of those trades ($6,000 in winning trades minus $8,000 in losing trades
The win rate made all the difference in this example.
Trader B scores bigger winners when his trades are correct, but he suffered more losses overall because his win rate was lower. It is a danger that can happen to anyone.
If you find yourself on the end of a losing streak, you might give up trading entirely, and that is the ultimate negative outcome that could occur. Be mindful of risk/reward and win rates and how they interact with one another.
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