The Rapid Forex e-Course

Lesson #16: Risk-to-Reward Ratios: How to Trade Like Insurance Company

Trading in the FOREX market is a challenging opportunity where above average returns are available to educated and experienced investors who are willing to take above average risk.  However, before deciding to participate in FOREX trading, you should carefully consider your investment objectives, level of experience and risk appetite.  Most importantly, do not invest money you cannot afford to lose.

In Lesson #13, we spoke extensively about Equity Management and Margin Control. In today's lesson, we want to cover some basics about how you can you effectively put the odds (of continuing to keep your account equity in the positive and make nice returns) in your favor even if you're "right" only 50% of the time.

Why do insurance companies consistently win? Insurance companies are consistently profitable because they use the laws of mathematics, probability and "special circumstances" to their advantage. They can pick and choose who they want to insure and the price they want to charge for insurance. Therefore, they "own" the game by being able to call the shots and rates that we must pay to enter into their playing field.

Research shows that older smokers tend to have high mortality rates. Therefore, the insurance companies charge excessive premiums for these types of people; while young healthy people tend to be the best risks, so lower rates are charged as the probability of paying a premium to this person's family is relatively small. This is not a level playing field, as the insurance company makes the rules and requires the charges to be paid.

Do the same with your trading.  Here's how:

First, look at the following table. It shows possible risk-to-reward ratios and the win ratios (the percentage of time you need to be "right") required to BREAK EVEN with a
trading system, method or strategy.

Risk-to-Reward Ratio (in pips)	Win Ratio Required to Break Even
40/20 (2:1)	67%
40/40 (1:1)	50%
40/60 (1:1.5)	40%
40/80 (1:2)	33.5%
60/20 (3:1)	75%
60/60 (1:1)	50%
20/30 (1:1.5)	40%
60/40 (1:2)	33.5%

If you were to toss a coin (heads you go long, tails you go short) you'd have a 50/50 chance of winning or losing (your trade can only be profitable or unprofitable. The market can only go with you or against you). If you were to trade with a 1:1 risk-to-reward ratio, then after a hundred trades you should theoretically have around the same amount of money left in your account (break even as shown above).

To manage risk effectively, it is necessary to find high-probability trades that have a 1:1.5 or greater risk-to-reward ratio. But this depends largely on the timeframe you are looking to trade.

For instance, in our book "Rapid Forex Surfing", one of our trading techniques teaches you how to go after 20 to 40 pip trades and use a 1:2 risk-to-reward ratio. So, for instance, you would set your reward for 40 pips and your stop-loss order for 20 pips (20 pips below the entry order). While statistically the odds start working against you for winning this trade, you can shift the odds in your favor by using "high probability" strategies. Let's say you try out the 1:2 ratio on all your trades for a while. And lets say you're only right 50% of the time (though you should be able to do better than that). Meaning half of the trades you win and half you loose (they hit your 20 pip stop). So, if you made 4 trades, and assuming 2 of them won and 2 of them lost, then look at what happened. You made 80 pips (2 x 40 pips) and lost 40 pips (2 x 20) for a net of 40 pips.

In Lessons #7 & #8, we talked about the need to identify potential trades based on chart patterns. The idea is that you collect a set of candidate charts, charts that have positive prospects for immediate trading. It is with these candidate charts that one can dig deeper into the possible trading of a particular currency pair. The identification of a probable trade centers around the proper identification of realistic entry and exit positions based primarily on support and resistance. Once you have properly identified the support and resistance points you can take those numbers, plug them into a simple spreadsheet and calculate the risk / reward. The simplest form of calculation involves nothing more than the following:

- Entry Price
- Stop Loss Target
- Stop Profit Target
- The resulting Risk-to-Reward Ratio

Here's an example of a trade that we were looking at recently. For clarity, let's follow the logic of the simplest risk/reward calculation one can make:

Currency Pair: EUR/USD
Type: Buy
# of Lots: 5
Entry Price: 1.3320
Stop: 1.3300
Target: 1.3360
Loss Risk: $1,000
Profit Potential: $2,000

To see if the potential play is worth wagering money on, one must determine what the potential losses are if your analysis is wrong and what the potential gains are if the analysis is correct. You should usually shoot for a 2:1 ratio - that is your potential profit should be roughly 2 times your potential loss. This is a rule of thumb that many traders use ... especially the good ones. In the example above, if one enters a trade at the price of $1.3320 with a defined stop loss exit of $1.3300 and a potential target exit for profits at 1.3360, then the ratio is roughly 2:1 (a bit less in this case, when you take into consideration the small broker pip spread). That's it. It's really that simple.

Recognize that once one has entered such a formula into a spreadsheet and begins using it, one can easily play with the numbers to make them work. For example, let's say that EUR/USD looks like a great BUY right now, but that the exit is really $1.3370 not $1.3360. Now, one could stretch the target to $1.3390, even though the resistance lies at 1.3380, in order to justify the trade, but the trader inside you knows this is not the case. When setting support and resistance points, one has to realize that if the numbers are fudged, the person fudging the numbers is the one hurt. It's their money that's on the line.

An easy way around the temptation of making the numbers work, is to always look at the support and resistance points first and allow as much slack in the numbers as makes sense. Now, plug in the entry price. Does the risk/reward make sense? If it doesn't, change the entry price, not the stop or target prices. Jiggle the entry price to the point where it makes sense and then simply wait until you get that entry point or pass the trade up. There are always more fish in the pond.

Ending Thoughts on this Lesson:

Always calculate your risk to reward ratio prior to making a trade. Refuse potential trades unless the risk-to-reward ratio is at least 1:1.5 or greater (preferably 1:2): that is for every dollar risk, there is a potential for 1.5 dollars in return. By calculating your risk to reward for every trade you will ignore marginal trades and you will identify your exit points before taking a trade. Recognize that you want to understand your exit criteria ... at the beginning of the trade, not sometime later. Once you are comfortable with simple risk to reward measurements and are identifying support and resistance zones reasonably accurately (see our book "Rapid Forex Surfing"), you can consider increasing the complexity of your formula to consider other variables such as time and confidence.

Stay Tuned for tomorrow's email from us. It will have the following Subject line: Lesson 17 - The Rapid Forex e-Course What to Look For in a FOREX Trading Course