Managing Risk & Reward/Risk Ratio

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Introduction

In order to make money we must first learn how to manage our potential losses (or risk).  Learning money management rules now, before you trade, will protect you in the long run and make your trading strategies more profitable.  It's all about balance and we must eke out every little factor we can to make a long run trading profit.  

Managing Risk

We've touched upon this in Module 6. Trading Psychology - Psychology of Money Management.  Losing money is easier to achieve than wining money.  Why?  Let's think about it.  If you have £/$/€100 and you loss 50%, you now have £/$/€50 (A drawdown).  Simple, right. To make the £/$/€50 back we must add another £/$/€50, which is 100%.  So you can see it's harder to win money back, than to loose it - The below chart highlights this.

Loosing is Easier Than Winning

If our trading system has a 90% winning trade ratio, we might think this is a fantastic system to use.  Not necessarily.  If the first 10% of trades loose, we may be out of money prior to the 90% of winners kicking in.  Also, think of this scenario.  The 90% of trades make on average £/$/€10 each and the 10% of trades loose on average £/$/€100 each, simple maths tells us that our money will soon run out with this strategy.

This is why money management is so important.  You never know when you're going to hit a loosing streak.  You need to have a strategy that will allow you to absorb these looses, which usually means risking small amounts of capital per position, usually 2% or so.  Think about this when developing your trading strategy.

Look at the below table to see how risking small amounts per trade helps you stay in the game longer. In this example you can sustain a larger amount of loosing streaks, before those wins re-appear.

Risk Management - 2% position size v 10% position size

It should also be mentioned that there are many other ways to manage risk, including the use of Options and other instruments as a hedge against unexpected price movements. These function in a slightly different and more complex way, and are beyond the scope of this module.

Correlated Markets

To complicate matters your risk per position, i.e. 2% of capital max, is better spread across correlated markets.  What is meant here?  Well, If you've taken a long position (2% of your capital) in Microsoft (or Gold) there's added risk if you also take a 2% position in Oracle (or Silver).  If you had taken both these positions your exposure would by 4% of capital on correlated markets.  It's best to spread your risk across non-correlated markets. We explain how to calculate market correlation in Mod 10.

Reward/Risk Ratios

Your Reward to Risk Ratio isn't always set in stone and really depends on what kind of trader you are.  For instance time frame matters.  A scalp trader, trading within an intra-day time frame may target a 0.7:1 reward to risk ratio; while a position trader, trading over long periods may target a 10:1 Reward to Risk Ratio.  The volatility of the market will also affect these ratios as will your actual entry point.

Let's look at a time frame example.  Let's say a scalp trader risks £/$/€50 per pip and has a 3:1 reward to risk ratio (as determined by testing his/her trading system) and he/she can afford to loose £/$/€200 (4 pips as per 2% of his capital).  A 4-pip risk, places a stop/loss 4-pips below the entry point (if you think the market will increase).  For a 3:1 Reward to Risk Ratio he/she must target 16 pips for the profit.  

In reality your broker may offer a spread of 2 points per trade.  This means in effect your target is 18 pips, as you need to overcome the spread to beak-even. So in reality your ratio is 18:4 (or 4.5:1).  

If you reduced your position size, you can widen your stop to achieve your desired Reward-to-Risk Ratio. For example, lets continue with the above example.  If you reduce the stake to £/$/€33 and if you think 18 pips is achievable (16 pips plus broker spread), you can take a 6-pip lose to achieve a 3:1 reward to risk ratio. Bear in mind the above trader will have calculated his potential profit, then the risk associated with his 3:1 strategy.  If the risks don't add up, i.e if it's more than 2% of capital, or if support is further than the desired risk, etc... THERE WON'T BE A TRADE.

Note.
Some Traders call it Risk-Reward-Ratio, so the ratio will look 1:3 and not 3:1.

To Sum Up

Loosing money is easy and please remember not to risk more than you can afford to loose.  2% of capital is a general guideline.  The reward to risk ratio is an important risk management and trading tool. It is important for beginning traders to take the extra time to perform this task because it can help to minimize risk in every trade. Waiting for the right ratio can take a long time. However, the benefits of waiting for a higher ratio are worth the effort and patience. You will know your risk and know your potential profit (remember profit targets can be established through technical analysis). Most importantly, you will know whether the trade is worthy of your money.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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Introduction

In order to make money we must first learn how to manage our potential losses (or risk).  Learning money management rules now, before you trade, will protect you in the long run and make your trading strategies more profitable.  It's all about balance and we must eke out every little factor we can to make a long run trading profit.  

Managing Risk

We've touched upon this in Module 6. Trading Psychology - Psychology of Money Management.  Losing money is easier to achieve than wining money.  Why?  Let's think about it.  If you have £/$/€100 and you loss 50%, you now have £/$/€50 (A drawdown).  Simple, right. To make the £/$/€50 back we must add another £/$/€50, which is 100%.  So you can see it's harder to win money back, than to loose it - The below chart highlights this.

Loosing is Easier Than Winning

If our trading system has a 90% winning trade ratio, we might think this is a fantastic system to use.  Not necessarily.  If the first 10% of trades loose, we may be out of money prior to the 90% of winners kicking in.  Also, think of this scenario.  The 90% of trades make on average £/$/€10 each and the 10% of trades loose on average £/$/€100 each, simple maths tells us that our money will soon run out with this strategy.

This is why money management is so important.  You never know when you're going to hit a loosing streak.  You need to have a strategy that will allow you to absorb these looses, which usually means risking small amounts of capital per position, usually 2% or so.  Think about this when developing your trading strategy.

Look at the below table to see how risking small amounts per trade helps you stay in the game longer. In this example you can sustain a larger amount of loosing streaks, before those wins re-appear.

Risk Management - 2% position size v 10% position size

It should also be mentioned that there are many other ways to manage risk, including the use of Options and other instruments as a hedge against unexpected price movements. These function in a slightly different and more complex way, and are beyond the scope of this module.

Correlated Markets

To complicate matters your risk per position, i.e. 2% of capital max, is better spread across correlated markets.  What is meant here?  Well, If you've taken a long position (2% of your capital) in Microsoft (or Gold) there's added risk if you also take a 2% position in Oracle (or Silver).  If you had taken both these positions your exposure would by 4% of capital on correlated markets.  It's best to spread your risk across non-correlated markets. We explain how to calculate market correlation in Mod 10.

Reward/Risk Ratios

Your Reward to Risk Ratio isn't always set in stone and really depends on what kind of trader you are.  For instance time frame matters.  A scalp trader, trading within an intra-day time frame may target a 0.7:1 reward to risk ratio; while a position trader, trading over long periods may target a 10:1 Reward to Risk Ratio.  The volatility of the market will also affect these ratios as will your actual entry point.

Let's look at a time frame example.  Let's say a scalp trader risks £/$/€50 per pip and has a 3:1 reward to risk ratio (as determined by testing his/her trading system) and he/she can afford to loose £/$/€200 (4 pips as per 2% of his capital).  A 4-pip risk, places a stop/loss 4-pips below the entry point (if you think the market will increase).  For a 3:1 Reward to Risk Ratio he/she must target 16 pips for the profit.  

In reality your broker may offer a spread of 2 points per trade.  This means in effect your target is 18 pips, as you need to overcome the spread to beak-even. So in reality your ratio is 18:4 (or 4.5:1).  

If you reduced your position size, you can widen your stop to achieve your desired Reward-to-Risk Ratio. For example, lets continue with the above example.  If you reduce the stake to £/$/€33 and if you think 18 pips is achievable (16 pips plus broker spread), you can take a 6-pip lose to achieve a 3:1 reward to risk ratio. Bear in mind the above trader will have calculated his potential profit, then the risk associated with his 3:1 strategy.  If the risks don't add up, i.e if it's more than 2% of capital, or if support is further than the desired risk, etc... THERE WON'T BE A TRADE.

Note.
Some Traders call it Risk-Reward-Ratio, so the ratio will look 1:3 and not 3:1.

To Sum Up

Loosing money is easy and please remember not to risk more than you can afford to loose.  2% of capital is a general guideline.  The reward to risk ratio is an important risk management and trading tool. It is important for beginning traders to take the extra time to perform this task because it can help to minimize risk in every trade. Waiting for the right ratio can take a long time. However, the benefits of waiting for a higher ratio are worth the effort and patience. You will know your risk and know your potential profit (remember profit targets can be established through technical analysis). Most importantly, you will know whether the trade is worthy of your money.

Technical analysis is not an exact science and although these ideas can increase the probability of making the correct trade, many will go against you and large losses can be incurred. Your own trading strategy needs to be formed and hopefully you'll be on your way to achieving this on completion of this course.

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