If there was just one thing you had to learn, a single secret about forex trading before joining the trading business; if it had to be that one thing, the holy grail that would guarantee you profitability, success and longevity, this would have to be it. I call it the forex trading jackpot. So free yourself from all distractions and carefully attentively read this piece. It might be the make or break to your trading career, the secret to the success you have for long sought – the ‘holy grail’.
There is an increased chance of losing money when trading in high-risk markets, including commodities and forex. This is because these markets are highly liquid and volatile, and are affected by a number of internal and external factors, including economic indicators. Being well aware of this fact, many scammers masquerading as gurus have created many websites selling very promising indicators and trading systems supposedly to help traders circumvent these risks and make obscene gains. They show you account histories with how much they make per day, the cars they have bought out of their holy grail systems, expensive mansions, and all sorts of dreams. Multitudes are lured into parting with their hard earned money to buy into these dreams only to realize it was all and unfortunately it’s too late by then. It’s all just made up, it’s fictitious.
All they were really looking for was a secret wrapped in two simple words “Reward:Risk”. But they were seeking it where it wasn’t. When trading the financial markets, there’s always a likelihood of loss. It’s paramount for traders to consider the amount of risk along with the potential profits before placing a trade, otherwise known as Reward:Risk ratio. This risk approximates the reward that a trader may earn should their position in the market play out favorably against the risk of loss should it go bad. Those that have traded forex for a reasonably long time call the reward:risk ratio the Holy Grail of Forex. And if many investors would turn around when they come across such a term, Forex traders would think twice because the Reward:Risk ratio really increases their chances of profitability.
Reward:Risk is simply a calculation of how much you want to risk versus how much you want to earn. The risk is the amount you invest in a single trade; a sum you don’t mind losing because it has the potential to generate a reward. The reward is the amount you want to gain.
Forex trading is a game of probabilities. A simple understanding of this could change the way you approach the markets and ultimately be the difference between success and failure. Viewing trade setups with the concept of Reward/Risk will help you make consistent money in the Forex market. Perhaps the most important fact to keep in mind about the power of reward/risk is that you will only see its power if you have the patience and discipline to trade consistently over a large enough series of trades. This approach to the markets demands you developing proper ways of analyzing price behavior and patterns and using discretionary ways to spot and trade setups.
Not every setup is yours to trade however good it appears; the high likelihood of trades moving more pips in your favor than risked based on the areas of support and resistance improves your edge in this forex trading business. An edge is in very basic terms the high probability of you trades earning more money over a series of trades over your losses regardless of the win rate. Rarely is this truer than in the application of the Reward/Risk concept in your trading of forex. When learning to think in terms of probabilities viewing markets in terms of reward/risk, it is necessary to consider the risk on a trade first, then the reward as a multiple of the amount you have to risk in taking the trade. When risk is considered first before the likely reward, you’re taking the preservative approach rather than the presumptive one by protecting the capital in your trading account first which is sure and already in your balance before seeking to add to it through the gaining of that which is uncertain and never guaranteed. Like its said, a bird in hand is better that two in the bush.
The security of what you already have is extremely important if the additions you’re seeking are to translate to any increase in wealth or growth of the account, otherwise you’re chasing after the wind. This helps ensure your longevity in the forex business while increasing your chances of making the money you desire overtime. However, it is not that simple as I might make it sound, and the risk/reward ratio that a trader adopts depends on their trading experience, style and strategy. If you are worried about the level of risk associated with trading the forex markets, there is always the option to trade on a demo account first to gain confidence before risking your money. The demo will enable you to practice with virtual funds before entering the live markets. You can also consider joining our mentorship program in the trading school where we help you avoid the pains of trial and error by teaching you our proprietary trading methods that shorten your learning curve.
Risk-reward is not the secret in itself, it’s the process that makes the secret. There has to be a high quality setup that’s formed at a right place in the market. That’s means taking into account support and resistance areas with a friendly trend. The trend increases the chances of price continuing in your direction. When for example considering a long position, support helps in determining the likely risk of loss while resistance helps in determining the reward potential. Once the reward ratio is favorably multiple times the risk of loss, with the likelihood of the trade working out in your favor given the prevailing trend, you have an edge in the market. This is the closest anyone one can make claim to a holy grail – trading with the odds in your favor with a great Risk to Reward potential.
Unfortunately, emphasis has heavily been placed on the win rate. This however hides or rather masks the poor quality of the high win rate traders, systems or strategies. The untold reality is that you can lose money trading a 95%-win rate system. This is because without proper risk management one single trade can erase the gains made from 20 winning trades. Seemingly paradoxically, you can profit trading a 30%-win rate trading system with proper risk management. This is where risk-reward ratios play as the most important metric in trading and a trader who understands the risk to reward ratio can improve his chances of becoming profitable. It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.
A reward:risk ratio is often used by traders to measure the expected returns of a trade against the amount of risk taken to realize the profit. To calculate the risk-reward ratio, you need to divide the amount you stand to lose if the price moves in an unexpected direction (the risk) with the amount of profit you expect to have made when you close your position (the reward).
Some of the most popular reward-risk ratios are 2:1, 3:1 and 4:1, and these will change depending on the strategy of the trade. Of course, there are other aspects which may affect the risk of a trade, such as money management and price volatility, but having a solid risk to reward ratio can play a strong role in helping you to manage your trades successfully.
In our own trading at Forex School Uganda, we usually use 3:1 Reward:Risk ratio and that’s as a minimum, because at times it gets to 4:1, 5:1, 6:1 and even higher. There’s no real standard to our reward:risk ratio apart from the minimum of 3:1. It all depends on what our strategy and trading plan indicates, and what direction Time Frame our trades are based. Trades taken based on the weekly time frames usually give a higher reward:risk ratio than those based on the Daily timeframe when our trades are taken on our entry time frames which are the 4hour for our swing trading strategy, and 1hour as well as 15minute time frames for our day trading strategies.
To better understand the power of reward:risk ratio, I will give you an example. Let’s say you take 10 trades using a reward:risk ratio of 3:1 and you lose 7 of those 10 trades taken, but are only able to win 3 of the 10 trades, and let’s assume you are risking 100usd on each trade meaning you’re aiming for three times as much on each which would be 300usd.
Lost trades: -7 x 100 = -700usd. So you lost 7 trades each of 100usd making a loss of 700usd
Won trades: 3 x 100 = 900usd. You won only 3 trades each at 300usd making a profit of 900usd
Won trades vs Lost trades: 900usd – 700usd = 200usd.
So you see with a win rate of only 30% you were able to make a profit of 200usd. The mistake traders often make is aiming for impossibly very unrealistically high rewards while risking unreasonably tight stops. As such, either their stops end up being hit prematurely because of fear or their targets never get reached and they lose what would have been great gains because of greed. Your targets ought to be realistically set at areas where there’s a high probability of price returning or reaching before a reversal.
Let’s look at a few trades illustrating how it’s all done on the trading charts
Our strategy indicated from a higher time frame an opportunity. And our job as traders is to follow the strategy whether we fill it’s a good trade or bad one. We know in doing so we have an edge. We don’t second guess or think twice because our trading is not based on emotion but our time tested strategies and thereafter manage it according to our trading plan.
Now we are timing our entries with precision according to our trading plan on a smaller timeframe. We entered with limit orders and went away from the market to let it do its thing while we mind our other businesses. We’ll return later every once in several hours just to manage it.
Result: our trade was triggered and went into profit twice as much as was risked. It however unfortunately reversed to close us out at breakeven.
With our high Reward:Risk targets, such occurrences are common. One might ask why we didn’t close it out at 2:1 and bank our profits? It’s just for the simple fact that it would be against our plan. We plan our trades and trade our plans. The plan is based on our time tested strategies that are very reliable to give us our desired profits in the end and longevity in the markets. It’s not based on emotions.
Days later, based on our strategy we were able to spot another opportunity. And as always, we rely on it and not our emotions. We don’t question it, second guess it, or think twice about taking the opportunity. If its according to our strategy, we’ll take it – every time, no exceptions. That’s what improves our edge in the markets. So when our strategy indicated to us another opportunity, we set our limit and stop orders which are all pending orders and we went away from the markets to let it do its thing while we me minded our other businesses.
Our trade was triggered on the very next candle according to our trading plan and we are now left to manage it. We’ll will check on it after every four hours. For now, we’ll let the markets play its game.
Twenty hours later, out target was hit and profits banked while we were away from the markets at a reward of three times the risk.
It is essential to wait for trades with a good risk/reward ratio. Patience is a virtue for a trader. With a solid reward:risk ratio, you don’t need a an extravagant win rate. Even a horrible one traded with discipline will make you profitable. If we take a win rate percentage required as a minimum to just breakeven trading (which means surviving in the markets), then a fraction of increase on the win rate percentage by just 1 percent would turn you from a breakeven trader to a profitable one. To get the reward:risk ratio as well as the breakeven trading percentage or otherwise known as a minimum win rate based on reward:risk ratio we will apply these formulae:
Reward:Risk Ratio (RRR) formula
RRR = (Take Profit – Entry) / (Entry – Stop loss)
Minimum Win rate Formula for Breakeven trading
Minimum Win rate = 1 / (1 + Reward:Risk)
Below is a tabulation from the above formulae of the winning percentage needed remain just breakeven. Just a small improvement by a single percentage point will make you a profitable trader
|Reward:Risk Ratio For Breakeven Trading
From the table above, you can see that even with a horribly poor win rate ratio you can survive in the markets if you have a solid Reward:Risk ratio. The less the Reward:Risk ratio becomes the high the percentage of winning trades you require to just break, which is extremely dangerous to you as a trader.
In conclusion, there’s no Holy Grail in Forex Trading, or financial markets trading in general. Ideally, we want to look for trade setups that give us a reward:risk ratio of at the very least 2:1. With this kind of ratio we can lose more than 50% of all our trades and make money trading forex. This is why Reward:Risk is commonly regarded as the “holy grail” of forex trading, though it’s not exactly an accurate assertion. In my experience, the closet you could ever come to a Holy Grail is the incorporation of Risk/Reward ratio together with the mastery of market psychology applied to high quality setup that are formed at the right place in the market with regard to support and resistance levels in line with a friendly trend.
These must be taken into account while creating a trading plan based on a strategy you have thoroughly tested in various market situations across different currency pairs or even markets over a period of several years and it turns a profit. Traders who can combine and apply these, following such a plan, consistently without deviation, can quickly realize with proof that you don’t need very high win rate to be a profitable forex trader, nor do you really need a large reward:risk ratio to make money.
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