A lot of traders out there focus too much on their win ration. You may say that you win 80% of your trades. Wow that is great, you must be a really good trader. However i would say a lot of these people lose a lot more on their losers then they make on their winners. This is because they do not manage their risk/reward very well and only focus on winning a high percentage of trades.
Lets say, I win 80% of my trades. Now each of my winning trades averages around 20 pips. But me, being focused on my win ration, I donít close loosing trades, instead i stick it out until it hits my stop loss or turns around. I end the week with only a 20% loss. Thatís great, i'm on my way to early retirement right? well lets see. What is your 20% of loosing trades all had 50pip losses or more?
So, if we traded with the above mentality, over 10 trades, we would have made 160pips, but then lost 100pips to end the week with a 60 pip win. Still sounds ok, but lets look at it a different way.
Lets say we forget win rations and look at a risk reward ration of 2:1. Using the above, we would have taken our 20pip profits on our winning 8 trades (80$) and still taken a loss on our 2 loosing trades however using a 2:1 risk reward ration we would now have only lost 20pips ending with a 140pip overall profit. Thatís more then double for the same amount of work!
But hang on you say, with small stop losses our trades could have been easily wiped out. Well this is where you need to think about how much you are willing to risk to make a profit as well as using your skill to judge where to place your stops.
The benefit of using risk reward is that you know how much you are going to lose if the trade doesnít work out and so you can plane better and have more confidence to enter trades. I can tell you know, just going out to trade Forex trying to win them all will only end in tears.
Most traders will tell you a good risk would be 2% and I think this is a good number to aim for. 1% is even better but I would use the 2% mark until you really feel confident in your trading strategy.
The below chart shows how good risk reward can help you become a profitable trader:
|Risk/Reward||% you need to be correct to break even|
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