Forex Risk-Reward Folly

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Forex Risk-Reward Folly

Postby George FXtrades » Tue Sep 08, 2009 7:06 am

Hello Edward,
I have read your set of notes on risk-reward ratio, and wish to compliment you on the most illustrative explanation on the topic available to newbies.

All traders have been told to establish risk management plans incorporating the risk-reward ratio enabling traders’ hard-earned money and expensive time in exchange to profits. Different professional traders recommend risk-reward ratios ranging from 1:2 to even 1:4. My opinion is that risk-reward ratio is arbitrary and depends upon the risk level one willing to take in conjunction with the profit target.

It is interesting to note that the larger the ratio is the greater reward the traders enjoy. However, I wonder how many traders follow strictly to the planned risk-reward ratios they formulated, because the outcome can be disastrous in a short period of time.

I am an intraday trader and find it extremely difficult to maintain the risk-reward ratio precisely. Taking a reasonable 1:2 ratio, and if I set the tight Stop Loss (SL) at 20 pips and take profits Limit (TP) 40 pips away, there is a strong likelihood the SL be strike first BEFORE the TP is reached under normal trading circumstances. Total loss comes to 60 pips painfully. However, the scenario is different on high performance trending situations.

The other side of the coin is to set the ratios to 1:3 or 1:4, but then one has to wait longer making the trade profitable, not forgetting the trend may stall, and reverses at its convenience to my disadvantage. Through my newbie trading experience, markets do everything possible to frustrate my goals. Sometimes I wonder whether the risk-reward concept is a Forex trading “folly” or a mathematical paradox.

Could you please advise as to how best in tackling the risk-reward ratio principle from a practical perspective.

Regards.
George FXtrades
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Re: Forex Risk-Reward Folly

Postby Edward Revy » Fri Sep 11, 2009 9:34 am

Hi George,

Good comment, good point.

I believe not many traders follow the risk-reward ratio plan today, and the main reason for that is: it is not as simple as we want it to be.
If we take the first screenshot from Risk-reward ratio example, there, as you can see, long before placing a trade, we have a clear idea about entry, stop and profit targets, which gives us an advantage of evaluating our risks vs rewards. Same when you trade with Fibs, pivots, channels, general support/resistance levels, Elliott waves etc. You have an advantage of knowing/planning your trades and possible outcomes beforehand. I doubt that any professional trader, manager, banker trades the market without a proper risk:reward strategy. When large money are at stake, you cannot afford to have high risk with vague profit prospective at any time.

Returning back to earth, where we, the general mass of Forex traders, try to get it right.
Not always we have a system that projects future profit targets, for example. If we look at the last screenshot from the above mentioned link, trading with moving averages or any other indicators that don't advice on future exits make it impossible to calculate risk:reward ratio in the first place. Should we commit to a fixed Stop loss and a fixed Take profit target then? The correct answer would be: it depends. And here is how:

1. If we take any trading system today and immediately apply risk:reward ratio management to it, for example: 15 pips stop, 45 pips profit. This would take us nowhere. Most likely it'll make more damage as we'll be taking one loss after another for the simple reason: our stop is too tight, our profit goal is unsubstantiated - it's random, based on our own 1:3 risk-reward "wish".

2. But, if we take any trading system, find a currency pair and a specific time frame for it, begin testing it while following a set of clear, not chaotic trading rules, make a journal to accurately document currency trading ranges, actual profits vs losses each time we trade, then also maximum profits vs losses we could have made in each trade.
Do this all for at least 3 months, while making sure the system met challenges of both: trending and ranging markets; then we will have statistics for this pair for this time frame, for this system in general, which will allow us to figure out the winning risk:reward ratio.

That's the difference! One has to approach money management constructively, not impulsively.
That's why it is not easy to achieve it with most of indicator based systems which make the lion's share of all systems nowadays. It takes time, lots of time!

Some systems are more flexible and easy to work with: for example, breakout systems based on certain trading session hours - you pick the pair, find the breakout hour/period, get in/get out, fixed stop, fixed profit, all based on average expectation calculated during previous testing period.
On the contrary, with Moving averages crossover and similar systems, it would be very challenging to find a justified winning risk:reward ratio.

Speaking about risk-reward concept as a Forex trading “folly” or a mathematical paradox. I have my own simple vision of it.
Trading Forex without good risk:reward ratio with a system that gives you 50/50 or even 60/40 chance to profit is a waste of time and money. Risk:reward ratio was introduced in the first place to give traders advantage in all trading conditions, so that even after 10 small losses versus 3-5 good gains the result remains positive.
If you develop and prove that your trading system gives you 80/20 or 90/10 or even better chance of profit, you may never need any risk:reward money management enhancement. For, example, when a trading record of a successful trader looks like: +10, +10, +15, +4, +10, +10, +5, +10, +10, +15, +5, +10, +10, +15, +10, +10, -60, and then +, +, +, +, +, + and so on consistently, who cares about -60 pips stop loss and only +10 pips profit target for each trade, if these trades are picked so accurately and are always in the right place with highest chances to get a winner?

So, here you have it. I tried to show the ways and solutions to money management dilemma, while everyone, as a smart trader, should find his way to deal with it:
- trade like a pro with trend lines, S/R levels, fibs, pivots, mainly stick to large time frames and do whole lot of analysis to ensure you've got a beautiful risk:reward ratio.
- use fixed SL and TP to meet risk:reward standards, but then, you've got to finally take it serious and make thorough evaluation/testing of your trading system before deciding on exact numbers.
- trade without risk:reward money management, but then you've got to own a really good trading system, I mean really good one, or you'll be repeating a history of hundreds of thousands of traders, who are either losing or moving nowhere today.

Hope it gives you an idea of how to avoid illusions about risk-reward management and approach it realistically.
Thank you once again for a great question and feedback!

Best regards,
Edward
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REGARDING

Postby Hanajanda » Mon May 30, 2011 10:42 pm

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Re: Forex Risk-Reward Folly

Postby ralphswurld » Wed Oct 19, 2011 12:24 pm

I've usually thought about the Risk Reward thing to generally be much more used in numbers, instead of preparing a system/strategy surrounding it.
The lesser the Risk:Reward (1:0.5) then the superior the possibility, in theory, of striking your take profit stage but then it takes only 1 loss to wipe out 2 winners. :(
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