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The Importance Of Risk Reward Ratios

Each quarter US FX brokers are required to report the profitability of their client’s accounts. Each quarter, year after year, the results are approximately the same – just 30% of traders run profitable accounts. That means 70% of traders will consistently lose money on their account.

In another study carried out by a large US FX broker involving some 11 million trades, it also became clear that traders enjoyed more winning trades than losing ones. For example, on EUR/USD 60% of trades studied were winning trades.

So, something is clearly not quite right? If EUR/USD traders were placing the right trade 60% of the time but only around 30% of traders had profitable accounts, something is clearly amiss.

Delving deeper in to the numbers, the problem becomes clearer.

In the study, traders on average on EUR/USD took a profit of 62 points, whilst the average loss on the same trade was 127 points. So, traders were willing to accept twice as much loss compared to gains. If a trader is willing to accept twice as much loss compared to gains, there is no way that this account is going to be a profitable account. Slowly the trader would run this account down to 0. This is extremely representative to what happens in trading accounts, time and time again traders are willing to accept significantly more risk than potential gain. This does not make for clever trading.

In order to decide whether a trade is worth doing, what you are risking must be smaller than what the potential gain is. If the potential gain is not at least twice the risk, don’t even consider placing the trade.

Working out Risk Reward Ratio 

So, when you think you’ve found a trading opportunity, work out the potential risk and the potential rewards. Start by plotting your stop. Don’t just pick an arbitrary number, use the market structure to place your stops. Here you should be thinking support and resistance, moving averages, trend lines, whatever it is that you want to use to decide where your stop should go. Don’t make the error of saying I want my stop 50 points away because that it the risk I am willing to take on.

Once you’ve decided on your stop, think about the profit target. In the same way as the stop loss, use the market structure to decide where best to place a target. Again, think Fibonacci, support & resistance, moving averages etc. Don’t say to yourself I want to have a 100 pip reward so I will place my target 100 points away. This is useless.

So now that you have a stop level and target level, as indicated by the market you need to decide if the trade is worthwhile. Is the potential profit at least double the potential loss? If so, then place the trade. If it is not, then don’t even consider placing the trade. This is a rule which should be written into your trading plan to ensure that you stick to it.