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Lesson Category: Module 5

Risk vs reward

What is risk vs reward ratio?

If you have spent some time trading before or if you have studied other traders then you will likely have come across the term “risk reward ratio”. This is a crucial aspect of trading that we must understand if we are to become profitable in the long run.

The risk reward ratio is simply the amount of capital that we are risking for the potential gain that we are targeting.

How to calculate R-R-R

Whenever we want to enter a trade we should calculate our risk/reward ratio first. All we need to have is our entry price, stop loss price, and our target price.

Example one

For the sake of simplicity, let’s use round numbers to explain how this works.

Let’s say we are going long on a currency with an entry price of $100.

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First we need to ask, how much would we lose if we lost our trade:

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Next, how much would we profit if our trade won? From this we can work out what our risk/reward ratio is 60/20 = 3:1. In this example our reward is three times the size of the risk.

Now let’s use an example using pips. Let’s say we are entering a scalping position trying to make a 10 pip gain and we set our stop loss at five pips.

In this case we stand to lose five pips if our trade loses and we win 10 pips if our trade wins.

10/5 = 2:1

In this example, our risk to reward ratio for the scalp would be 2:1.

Easy enough, right? But what does this mean and how can it help with our trading?

Why is risk vs reward important?

When we know what risk reward ratio we will be trading with we can easily find out what winning percentage we need in order to be profitable traders. This is very handy to know as you can always stop and take stock of how you are performing and just how far away you are from becoming a winning trader.

Let’s take a look at what we would need to do to break even if we trade at some different risk to reward ratio.

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The problem with too high a RRR

As you can see, the required winning rate drastically reduces as we increase our risk to reward ratio.

Sometimes when newbie traders see this, their eyes light up with the sight of the low winning rates, and they think that it would be easy to attain these levels and instantly become a winning trader. While there is some logic to be found in this, there are a few drawbacks that we need to consider.

Firstly, the higher we go with the RRR, the longer our trades will last, and the more exposure we have to the market. As we have mentioned many times throughout this unit, trading is mostly a mental game.

The longer we expose ourselves to the market, and the longer we have open positions, then the more chance there is that our emotions will get the better of us and interfere without trading.

Secondly, if we have a long RRR, we will get stopped out more often than not, and we will have to overcome dealing with many consecutive losses, which can be a tough burden for even the most seasoned of traders.

Lastly, traders will often cut their trades short when they are in these types of trades and will take their profit early. While at first, this may seem like a bad idea, but what they are actually doing is dooming themselves to being massively unprofitable.

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If they cut their winning trades short every time, they will not be reaching that four, five, or six times target that they were aiming for.

That means that they will not be making up for all of those small losses that they have racked up, and they will often never reach the high targets that they set.

Note: It is entirely possible to be a winning trader using high risk to reward ratios, but it is much more difficult. For newbie traders, it is recommended to stick to a lower ratio while starting out until you can find your sweet spot.

What RRR should I use?

It all depends on what type of trader you want to be, however, most traders seem to agree that somewhere around the 3:1 RRR is somewhat of a sweet spot.

When selecting a 3:1 RRR, you will still hit a large portion of your trades without getting continually stopped out and left feeling demoralised.

A 25% win rate using this RRR is definitely achievable using the strategies that we have already brought you in this course, you just need to stick to your trading plan and ensure you trade with discipline every time.

One of the main dangers comes with cutting your winning trades short, so be aware of moving your stop loss to a breakeven position when you don’t need to.

Constantly manage your trade for signs that your initial theory has now become invalid. If it has, it is perfectly fine to exit.

Final word on RRR’s

At the end of the day, the risk to reward ratios are not set in stone. You should chop and change them to fit in with your trading plan and set your targets based upon key levels that you identify in the market.

If you want to set a trade up with a RRR of 3:1 but you see that there is a significant resistance level where 2:1 RRR would be then it would certainly make sense to adjust your trade to avoid that.

The risk to reward ratios should be used as a tool to guide us with our targets and help us trade, not to hinder us from applying solid trading fundamentals to each trade.

Risk management basics

Forex is all about having a plan and sticking to it. As soon as veer away from the plan you are unnecessarily exposing yourself to the market in ways that you didn’t prepare for.

Whether that be trading with more money that you are prepared to lose, or using a different strategy than you have practiced and planned to stick to, straying from your plan can be costly.

That said, let’s look at some key areas of risk management for you to follow when trading the markets.

Position size

You need to work out exactly what percentage of your trading balance you are willing to risk on each trade, once you have that information you can decide what size of lot you are going to buy and how many of them you will purchase.

Most professional traders risk 1% or less of their account every time they enter a trade.

So if you have a $10,000 account then you should be risking no more than $100.

You should keep this number consistent at all times. Do not risk 4% on one trade, 1% on the next and then 3% after that.

Choose your account risk and then stick to that at all times. Consistency is key.

Setting stop losses/ pip risk

Now that we know how much we are willing to lose on our trade we need to calculate where to set our stop loss.

We will go into much more detail on stop losses in the next section, but for now just remember that the stop loss should be set at a predetermined distance from our entry point that signifies our maximum amount of risk per trade.

To do this, we must calculate how much one pip movement is worth to our account and then set our stop loss accordingly.

For example, if one pip is worth $1 to us and we have a $10,000 dollar account then the maximum we can afford to lose using a 1% risk is 100 pips.

Taking profit

This is secretly one of the hardest parts of trading, where to exit when we are in profit. We must use ur indicators and trade research to determine key points to exit our trades.

We should always enter a trade with a key idea of where our entry and exit points are, both stop-losses and profit taking areas.

Again, we will go over this in detail in a few sections time.

Keeping disciplined

As we have mentioned many times over this course, consistency and discipline is vital. Follow your trading plan, stick to your risk management strategy with effective position sizes and always place appropriate entry and exit points.

Why is it important

Having a solid risk management strategy that you adhere to is probably one of the most important aspects of successful trading.

Making a mistake with a trading indicator, placing a support or resistance incorrectly, or even hitting short instead of long are all redeemable errors. We are human, we all make mistakes. However, if we don’t stick to our risk management strategies, these small mistakes can wipe out our entire trading balance. This is exactly what we are trying to avoid.

Good things come to those who wait. Trade patiently, diligently, and with discipline and you will be half of the way there.

Note: If you stick to these tips and practice proper risk management you will likely never put yourself in a position of wiping out your account.

Take-profit

What is a take-profit?

Taking profit is essentially what we want to be doing each and every trade we take. A take profit is the place where we set our exit trade to get out of the market for a profit.

Similar to a stop loss, we should set our take profit trade at a predetermined place and not just a random point.

Newbie traders often make the mistake at aiming for a certain price level or a predetermined percentage gain.

These are just arbitrary levels and are not based on any sort of technical analysis and will almost certainly mean that you’re leaving money on the table.

Why is it important?

Taking profit is arguably one of the most emotionally and technically challenging aspects of forex trading.

People often struggle with taking profits early and seeing their trade run away on a huge move that they have now missed out on. This can really test even the best trader’s mental strength.

Mastering the art of taking profits is crucial for successful forex trading. If we get out too soon we could see our trade run away and we have missed out on profits.

On the other hand, if we don’t set appropriate take profit levels we could see our winning trades become losing trades if we have unrealistic targets.

Where to set our take profit trades?

There are many methods that we can use to take our take profit levels, here are a few of the most common:

  • The key support and resistance levels
  • MACD crossovers
  • RSI overbought/oversold levels
  • RSI divergences
  • Use your predetermined risk rewards ratio (more on this in the next section)

Look for critical levels in the market that could prove as obvious obstacles. If you are in a long position, it probably wouldn’t be a good idea to set your sell order above a significant resistance point.

Every trade you take will present a delicate balancing act between being over cautious and being too greedy. To eliminate this, set your targets at key levels in the market that take out the subjectivity in your trades.

Multiple take profit zones

Some traders find it beneficial to spread out there take profit orders over two or more areas in order to take their profit incrementally.

This can really help with the mental side of trading as once you have reached your first TP (take profit) level your trade will remain in profit even if it dips below your initial entry point.

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This is usually more common in swing trades that are targeting larg pip movements over one to a couple of days. If you plan to do this then it makes sense to set the TP orders at or just before key levels in the market.

In the next section, we will look at risk-reward ratios that will help you to set better targets for your take profit orders.

When & when not to trade

Most of the information you will find when you begin your trading journey will be on how to best spot market opportunities and identify signals when they present themselves.

While, of course, that is extremely useful information, it could be argued that it is equally important to know when NOT to trade and to avoid the market all together.

Whether it be for a personal reason or due to macroeconomic events out of your control, there are certainly moments where you would be better waiting on the sidelines to trade another day.

Personal reasons to avoid trading

First of all let’s look at some times when you shouldn’t trade due to personal reasons. Some of these may seem obvious but you would be surprised how many people ignore these warning signs and blow away their entire trading capital.

Trading when highly stressed/ tired

If you are stressed/tired then you will not be performing at your best and your decision making will be sub par. It’s far better to take a rest and come back when you are feeling fresh again.

If you must do something to do with trading then it would be far better to use this time to study or to paper trade rather than using live funds.

During emotional times

Trading is no different to any other job that you may have in the real world. If you have some serious family issues or if you are under a lot of mental pressure then it would be better to take some time off.

If you ever feel like your emotions are getting the better of you then save the trading for another day.

Trading when surrounded by too many distractions

It’s essential that you are 100% focused when you are trading. You should always be monitoring your positions for how your trades are performing and how the market behaves. It’s hard to learn from the market if you are constantly distracted.

Trading after a heavy loss or during a continued losing streak

After a big loss there is no way you can trade with a clear head. Step away from the computer and come back another day when you have refocused and recovered from the loss.

It would be even better to analyse the trade to see what you did wrong so that you can avoid making a similar mistake in the future.

When you are at work

This ties in with a few of the aforementioned points. If you are at work you likely will not be able to focus and you will be distracted on multiple fronts. Also, we don’t want you to lose your job just yet! Wait until you’re bringing in the big bucks first.

Fundamental and technical reasons to avoid trading

The market reasons for not taking a trade are situations that are way out of your control.  Certain events have the potential to send shockwaves through the market, causing huge swings and periods of volatility.

Here are a few examples of such events. During these times, it’s almost always better so sit out and watch from the sidelines.

Large news events

News often plays a big role in the price fluctuations in the market. Some currencies are heavily tied to commodities while others will move depending on how their stock markets perform or sometimes even individual companies.

Keep one eye on the news and make sure you understand what impacts the currencies that you are trading.

Political elections results

This is one goes without saying. Keep an eye on key election dates as the price can fluctuate wildly based on election results.

High profile speeches and budget releases

High profile speeches and budget releases can affect the market considerably. Be aware of when they take place and wait for them to pass by so you can avoid the market uncertainty and resulting speculation.

Bank holidays

A large portion of the trading volume comes from the banks. When they are closed during the bank holiday it means the markets are far less liquid than usual. This can cause market stagnation and occasionally erratic price movements.

Market open/ close

It’s a good idea to try and avoid the market/open close as it can often bring increased volatility. Traders are frantically trying to open/close their positions which can cause erratic price movements.

A word on overtrading

As the markets are open 24 hours a day, five days a week, there are a huge number of opportunities for traders to take advantage of. This is both a blessing and a curse.

Overtrading is one of the major reasons why traders lose money. You should not be entering a position at every signal that you see. As the old saying goes, “good things come to those who wait.”

It pays to wait for clear cut setups where a number of your indicators are all pointing in the same direction. Stick to your trading plan religiously, don’t chase your losses, and keep your trading decisions as objective as possible.

Stop-loss

We have mentioned stop-losses many times in this course so far, and for good reason, we need them! Time to dive a little deeper into the specifics.

As you know, the forex market can be volatile and difficult to predict at times. Even the best traders get it wrong and find that the market moves in the exact opposite direction to what they predicted.

Even if all our indicators are pointing in one direction it is still entirely possible that the market can move violently in the other. A major economic event, a new banking policy, and even strong rumours can affect the price out of nowhere, we must be prepared for this.

A lot of newbie traders will make the mistake of riding the trade it and hoping (praying) that the market will turn back in their favour. Others will cut their loss immediately as soon as they see it turn red and unfortunately, both of these strategies are incorrect.

What we need is a stop-loss. Simply put, a stop loss is an order that we place into the market that automatically executes when the price hits a certain level. It removes all the stress and anxiety from trading without a stop loss and acting the market run away with our entire trading balance at risk.

Sometimes it’s best to cut your losses and live to fight another day.

Where to place our stop loss

As we touched upon earlier, we can calculate precisely how many pips we are willing to lose for each trade.

If we know that we only want to risk 1% of our account, we should calculate how many pips that equate to, and then we know the maximum point at which we can place our stop loss. However, this is NOT the best strategy. We should always set our stop-loss at the point of invalidation.

This means that we should place our stop loss at the point where the reasons why we entered our trade are no longer valid.

For example, let’s say that we expect the price to bounce off a support and reverse into an uptrend. Rather than setting our stop loss at 100 pips below the support, we could set it at maybe 10-15 pips below the support.

That way, we know that our initial trade theory has been proven to be wrong (the support did not hold), and we can exit for a small 10-15 pip loss.

For the sake of this trade, it would be unnecessary to lose all 100 of our allocated pips based on our risk management strategy.

This is the MAXIMUM you are willing to lose on a trade, not how much you should lose each time.

Trailing stop-loss

Other than a setting a regular set stop-loss we can also utilize what is called a trailing stop loss.

A trailing stop loss will move based on fluctuations that occur during the trade.

For example, if you set a BUY order on EUR/USD at 1.1000 with a 50 pip trailing stop at and the market moved up to 1.1050 then the trailing stop would move up to 1.1000.

Every-time the trade moves in your favour the trailing stop loss will trail behind by 50 pips. This is a great way to lock in profits and attempt to ride successful trades out for as long as possible.

The stop loss will only trigger once the market has moved against you by 50 pips.

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Moving your stop-loss to your entry position

One thing that traders like to do is to move their stop loss to the point of entry when a trade goes in the favour. This can be a great tactic as it essentially removes all risk from the trade and it effectively a “free shot” at making extra profits.

While this can often be a good idea and can real help remove the stress from a trade it can also mean that you turn some winning trades into break even ones

Sometimes the market can fluctuate violently and it can take out your stop loss before carrying back on its trajectory.

If this happens you can see your trade closing before you get to your profit taking zone and you have just missed out on a winning trade.

While it’s okay to do this sometimes, it’s almost always better to set your stop loss at the point of invalidation.

Creating a trading plan

First things first, we need to create a trading plan. As the old saying goes, “fail to prepare, prepare to fail.”

If we just hit the markets any time we like without giving much thought to what our plan is and why we are doing what we are doing, then you can guarantee that you will be recording losses before you know it.

Granted, you may get lucky for the first few times, but eventually, that luck will run out, and the lack of planning and a clear strategy will undoubtedly show.

A trading plan, not a trading strategy

When we say trading plan we don’t mean that you need a clear idea of where you will enter and exit a trade, instead we mean you need to have an overall sense of what your goals and ambitions are for trading and what sort of funds and time you can allocate towards these goals.

The trading plan should be personal to you, honest, and realistic. This is what is going to help you decide, what, when, and how much you want to trade.

This should be the foundation of your trading and should be referred back to when you feel yourself getting into a rut, or even to stop yourself getting carried away when you’re on a winning streak.

A solid trading plan should help you to keep a logical trading mind and keep your emotions in check by helping you to make more objective decisions and fostering a trading discipline which is so vital to becoming a profitable trader.

How to make a trading plan

Here is a template to follow when making your plan, be sure to include all of these elements and anything else you feel is important.

1.   Write down your main motivation for wanting to trade

As with anything in life, it never hurts to stop and take stock of what we are doing and why it is we are doing it.

Why do you want to start trading? Do you want to become a full-time trader, add a little extra income to your full-time job, or do you want to become a fully-fledged expert, and find a job on Wall Street?

Whatever it is, write it down and keep this in mind when you are trading. It helps to keep things in perspective later down the line.

2.   How much time can you commit to your new trading career?

How much time are you willing to commit to this new hobby/career? Are you a stay at home parent who can commit 40 hours per week or do you run five jobs and have only a few hours spare? Can you trade during work hours, or not?

If you only have a limited amount of time you need to plan efficiently and make sure you are fully concentrated when doing so. Set aside some dedicated trading time and stick to it, no more, no less.

3.   Clearly outline your goals and what you want to achieve

Similar to the first point, but this time you should write down exactly what you want. Use numbers!

For example, “I want to increase my trading balance by 20% within the first 12 months”. That way you can hold yourself accountable and refer back to your goal when you need to.

4.   How much capital can you raise for trading?

This is important. Never risk what you cannot afford to lose. Seriously.

This gets said a lot but it is one of the most important factors in trading. If you are overinvested that you will not be trading efficiency, it is simply impossible.

Losses will be harder to take and you will likely be trading with scared money which could lead you to setting stop-losses too tight and taking profits too soon. Keep it realistic.

5.   Risk tolerance

We will go into this in more detail later on in the unit, but for now, right down how much you are willing to lose on one trade. The smaller the better of course. Somewhere around 1-2% per trade is reasonable.

It also makes sense to have a daily loss limit. If you lose 2% of your trading balance then call off the trading for the day. If you don’t you will likely chase your losses and trade poorly.

6.   Pick a currency pair and a time frame

Don’t be the jack of all trades and the master of none!

It can be very overwhelming to have 30 markets up on your screen with indicators all over the place.

Save yourself the stress and stick to one currency pair and one time frame. That way you can quickly learn how that market behaves and how you can best exploit it.

When you get more comfortable you can branch out when you are ready.

7.   Create a trading diary

Last but most certainly not least, create a trading diary. Keep track of everything. There are alot of great tools that you can use online to help you keep account of your trades.

Some of the most important things to write down are the reasons for entering a trade (hopefully there is more than one), how the trade performed, and a post-trade analysis.

By doing this we keep ourselves accountable for every trade and it highly reduces the risk of erratic and sub-optimal trading.

Be sure to go over your diary regularly. This will help you to highlight any weak points that you need to improve on.

Consistency when you trade

Consistency is absolutely crucial to becoming a winning trader, especially in the long run. So how do we achieve this?

Well, we should be aiming to make our trading as OBJECTIVE as possible. This means we need to take our emotions out of the trading process as much as we can by having a clear trading plan and a set strategy to follow.

This means that a large part of the decision-making process has been removed from the equation, and we can simply focus on scanning the market for good setups, and we can monitor the performance of our trades.

Consistent risk

One of the most vital areas we must maintain consistency in is with our level of risk. If we overexpose ourselves on a trade and end up losing, then we can wipe out a considerable part of our trading capital. This is something we want to avoid.

Calculate how much of your trading balance you are willing to risk on each trade. As we have suggested, this should be somewhere close to the1% mark.

Once you have this figured out, it is best advised to trade with consistent lot sizes so that you can keep your market exposure at the same level each time you trade.

This way, you will become more comfortable with trading that lot size until you are ready to increase your stakes.

Consistent risk-reward ratio

Many people like to trade with a consistent risk-reward ratio as it allows them to analyse their trades on a macro level and compare their actual win rate with their desired win rate.

For example, if you trade with a 2:1 risk-reward ratio, you know that you need a 33% win rate to break even. If you keep track of all your trades, you can easily see how you are performing and just how far above or below breakeven you are hitting.

If you switch between RRRs, it can become hard to keep track of your win rate for each ratio. 

The best way to overcome this is to keep track of your trades and write them into your trading journal every time. Make a note of the RRR you used and record the outcome; that way, you can split test your results and see which RRR is performing best for you.

If you stick to one RRR then you will be able to understand how the market behaves during these types of trades and this will help you improve as a trader much quicker.

The skills required to become a great 1:1 RRR trader are far different than those who trade at a 10:1 RRR – stick to one area and hone your skills there. 

Note: As always, the RRR is not the be-all and end-all. Set your entry and exit points strategically and be aware of key market levels.

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