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TheRisk/RewardCalculation

Dividetheamountofmoneyyoustandtoloseifthetradeisunsuccessful(risk)bythe
amountofmoneyyoustandtowinifthetradeissuccessful(reward).

Forexample,letssayatraderisthinkingaboutbuyingtheGBPUSDpair.Basedupon
wherehewantstoplacehisstoplosshestandstolose$50ifthetradedoesntworkout.
Thatisthepotentialrisk.Andletssaybaseduponwherehewantstoplacehistakeprofit
hestandstowin$150ifthetradedoesworkout.Thatisthepotentialreward.
Thetraderiswillingtorisk$50forapossible$150reward;thatisa50:150or1:3
risk/rewardratio.
Herearesomeotherexamplesofrisk/rewardratios:
Ifyourisk$100forapossible$200reward;thatisa100:200or1:2riskreward
Ifyourisk$200forapossible$800reward;thatisa200:800or1:4riskreward

WhatisanAcceptableRisk/Reward?
Mosttradersconsider1:2(risking1tomake2)astheminimumrisk/rewardratio.The
preferenceis1:3orhigher.Thethinkingisifyouaregoingtotaketherisk,theamountof
moneyyoustandtogainshouldbesubstantial.Onthesurface,losingsmallandwinning
bigsoundslikeasolidstrategy.Tradersarealsoquicktopointoutthatyoucouldwinless
thanhalfyourtradesandstillmakeagoodprofitusing1:3orhigherrisk/rewardratios.

TheShortcomingofRisk/Reward
Therisk/rewarddoesnotaddresstheprobabilityofthetradebeingsuccessful.Ifthe
risk/rewardratiois1:3itmeansthepricehastotravelthreetimesasfarforthetradetobe
successful.
Sothefactthattheprofitisthreetimesasgreatasthelossistomakeupforthefactits
threetimeslesslikelytohappen.Andthelossisonlyathirdoftheprofitbecauseitis
threetimesmorelikelytohappen.
Forexample,letsassumethetraderbuyingtheGBPUSDpairistrading1minilotandis
risking$50(50points)totryandmake$150profit(150points).Thatisa1:3riskreward.
Thisishowitwouldlookonthechartatthetimethetradewasenteredinto:

GBPUSD Daily Chart August 7, 2014

HowtoProperlyUseRisk/Reward
IntheaboveGBPUSDexampletheriskwas50points($50)andtheprofittargetwas150
points($150).Theprobabilityisyouwillwinoneoutoffourandthatamountstoa
breakevenresult:
1winof$150
3losesof$50=lossof$150
Thatsbreakeven
Noadvantagethere
Theadvantagecomeswhenyouthink(baseduponyouranalysisandexperience)thata
tradewitha1:3riskrewardhasbetterthana1in3chanceofsuccess.Whenthatisthe
caseyouaregettingabetterpayoffthanyouthinkyoushouldget.Andthatrepresentsa
speculativeedge.
Forexample,ifyouthoughttheGBPUSDbuytradehada1in2chanceofincreasing150
points(profittarget)beforedecreasing50points(stoploss);youwouldhaveaspeculative
edgebecauseifyouwinthetradeyouwillbepaidoffatthe1in3chancesrate($150
profitfora$50risk).
Thatinessenceisattheheartofalltrading;anactionableopinionofpayoffversus
probability.

By Jimmy Young
Risk/RewardMovesInverselytoFavorablePriceAction
Hereisanexample.LetssayyoubuyGBPUSDat1.6600;youplaceatakeprofitorderat
1.6700andastoplossorderat1.6500.Yourriskis100pointsandyourpossibleprofitis

100points.Therisk/rewardis100:100,whichisa1:1riskrewardratio.

Nowletssaythetrademovesinyourfavorby80pointssoGBPUSDisnowat1.6680.
Letsrecalculatetheriskreward;theriskis180(1.66801.6500)andtherewardis20
(1.67001.6680).Therisk/rewardis180:20,whichisa9:1risk/rewardratio.Youarenow
risking9tomake1.

SowhyisthisImportant?
Becauseitchallengestheconceptoflettingyourprofitsrun.IfIweretoask10peopleif
theywantedtolettheirprofitsrun(tryforthatlast20points)orclosethetradeandtakethe
80pointsprofit;9outof10,ifnot10outof10,wouldsaytakethe80points.Thepointis
this;lettingyourprofitsrunisnotworththeriskatsomepoint.

HowDoesRisk/RewardMoveinRelationtoUnfavorablePriceAction?
Hereisanexample.LetssayyoubuyGBPUSDat1.6600;youplaceatakeprofitorderat
1.6700andastoplossorderat1.6500.Yourriskis100pointsandyourpossibleprofitis
100points.Therisk/rewardis100:100,whichisa1:1riskrewardratio.
Nowletssaythetrademovesagainstyouby80pointssoGBPUSDisnowat1.6520.
Letsrecalculatetheriskreward;theriskis20(1.65201.6500)andtherewardis180
(1.67001.6520).Theriskrewardis20:180,whichisa1:9risk/rewardratio.Youarenow
risking1tomake9.

SowhyisthisImportant?
Becauseitchallengestheconceptofcuttingyourlosses.IfIweretoask10peopleifthey
wantedtocuttheirlosses(notriskthatlast20points)orkeepthetradeopenandpossibly
makebackthe80pointlossplusanadditional100pointsprofit(180pointturnaround);9
outof10,ifnot10outof10,wouldsaykeepthetradeopenandriskthelast20points.
Thepointisthis;cuttingyourlossestosaveasmallpartofyourrisk(inthiscasesaving
thelast20points)isnotworththeeliminationofanychancetorecoverandprofitfromthe
tradeatsomepoint.

Sowhatsthesolution?
Atrailingstoplossthatkeepstheriskrewardclosetowhatitwaswhenthetradewas
enteredisonepossibility.Anotherpossibilityismultiplelots.

MultipleLotsLockinProfitsandReduceRisk
Thistrademanagementstrategystartswitha1:1risk/rewardratio.Fromtherearelatively
smallfavorablepriceactionreducestheriskby83%anddramaticallyimprovesthe
risk/rewardratio.Anotherrelativelysmallfavorablepriceactioneliminatesallriskand
locksinaguaranteedprofit.

Hereisanexample:

1.Buy3minilotsofGBPUSDat1.6600
Stoplossis$120
Sell3lotsifthepairgoesdown40points(1.6560);riskis3X40=$120
Takeprofitis$120
Sell1lotifpairgoesup20points(1.6620);profitis1X20=$20
Sell1lotifpairgoesup40points(1.6640);profitis1X40=$40
Sell1lotifpairgoesup60points(1.6660);profitis1X60=$60
Risk/rewardis$120:$120,or1:1riskreward.

2.Thefirstactioniseither
GBPUSDgoesdown40pointsandthestoplossistriggered
Sell3lots40X3=$120loss
Bottomlineyoulose$120
GBPUSDgoesup20pointsandthefirsttakeprofitistriggeredandthestoplossisraised
by20points
Sell1lot20X1=$20profit
Remainingpositionislong2lots
Movestoplossupby20points(to1.6580from1.6560)onthetworemaininglots

3.LetsassumetheGBPUSDpairincreased20pointsto1.6620andthattriggeredfirst
actionb;nowletsrecalculaterisk/reward
Long2lotsweboughtinitiallyat1.6600
Thestoplossisnow1.6580
Maximumriskonthetworemaininglotsis20X2=$40
Theotherlotwasclosedataprofitof$20(1X20)
Thereforeafterfirstactionb;themaximumlossis$40onthetworemaininglots,which
wouldbepartiallyoffsetbythe$20profitonthelotalreadyclosed.Whichmeansalossof
$20isnowtheworstcase(therisk)
Thepotentialrewardremainsthesame$120
Sold1lotafter20points(1.6620);profitis1X20=$20
Sell1lotifpairgoesup40points(1.6640);profitis1X40=$40
Sell1lotifpairgoesup60points(1.6660);profitis1X60=$60
Therisk/rewardis$20:$120or1:6risk/rewardratio
Theriskwasreducedby83%,from$120to$20
Yournowrisking$20tomake$120
Yourrisking1tomake6

4.Thesecondactioniseither

GBPUSDgoesdown40pointsto1.6580andthestoplossistriggered
Sell2lots20X2=$40loss
Partiallyoffsetbythe$20profitonthefirstlot
Bottomlineyoulose$20
GBPUSDgoesup20pointsto1.6640andthesecondtakeprofitistriggeredandthe
stoplossisraisedby20points
Sell1lot40X1=$40profit
Sold1lotearlier20X1=$20profit
Remainingpositionislong1lot
Movestoplossupby20points(to1.6600from1.6580)ontheoneremaininglot

5.LetsassumetheGBPUSDpairincreased20pointsto1.6640andthattriggeredsecond
actionb;nowletsrecalculaterisk/reward
Long1lotweboughtinitiallyat1.6600
Thestoplossisnow1.6600
Maximumriskontheoneremaininglotis0X1=$0
Thefirstlotwasclosedataprofitof$20(1X20)
Thesecondlotwasclosedataprofitof$40(1X40)
Thereforeaftersecondactionb;theworstcase(therisk)isabreakevenonthethirdlot
anda$60profitonthefirsttwolots
Thepotentialrewardremainsthesame$120
Sold1lotafter20points(1.6620);profitis1X20=$20
Sold1lotafter40points(1.6640);profitis1X40=$20
Sell1lotifpairgoesup60points(1.6660);profitis1X60=$60
Therisk/rewardisnowoffthechartssotospeak
Worstcasemake$60(ifstoppedoutof3rdlotat1.6600,whichisbreakeven)
Bestcasemake$120(if1.6660takeprofitisreachedonthe3rdlot)

Summary Diagram


WhenitsbesttouseMultipleLots
Worksbestwithmomentumtypetrades.Thatisbecausethepricejustneedstokeepdoing
whatithasbeendoingmostrecentlytoreachthatfirstactionandreducetheriskby83%
andimprovetherisk/rewardratiofrom1:1to1:6.
AnotherthingIlikeaboutmultiplelotsisthefactapositiveactionoccursafter20points
andanegativeactionhappensafter40points.Allotherthingsbeingequal,itstwiceas
likelytogetapositiveaction;becausepriceonlyneedstocoverhalfthedistance(20
versus40).
Thereisnorequirementthatyouusethe20,40,60;itsjustwhatweusedhereasan
example.Whatiskeyistousethesameproportions(e.g.15,30,45;or25,50,75).

By Jimmy Young

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