The Shocking Truth About Risk-to-Reward

Forex Smart Tools Newsletter ~ Volume Sixteen

Have You Been Tricked By Risk to Return Planning?

In so many of the courses we've taken and books we've read, the concept of having proper risk to return is put forth as though it is the most important axiom or rule possible in trading. You've probably heard your fellow traders say things like "Oh I never enter a trade unless I have a 1 to 2 risk to reward expectation."

Do we believe in this? Well - we want to spend a few newsletters showing you that there is more to this equation than meets the eye - and also show you why, even if you believe in this kind of equation, you still may be fooling yourself.

We're going to show you how a few of the features of the Calculator and Trade Log work, so you can prove or disprove to yourself whether you are getting the reward for your risk that you think you are. Read on....

Good trading to you all, Evelyn & Mindy
APs, Registered Commodity Trade Advisors
www.forexSmartTools.com    skype: forexSmartTools    twitter: @forexsmarttools

Lesson Sixteen - Part A: The Concept of Risk to Reward

The Forex Smart Tools Calculator includes a formula we calculate for you that shows what your intended risk-to-reward will be. Look at the bottom line of the Trade Plan page to see this. Below you'll see a close up detail (to see the full trade plan page for this example trade, click here).

In the example we display here, a trader is planning a trade in which he will risk 30 pips and believes he can make 60 pips as his final target. Risk is shown in the red column and reward in the green column. He anticipates making twice as much money as he risks, gaining $552 while risking $276, so his risk to reward ratio is shown as 2 (we show three decimal accuracy, so it reads 2.000).

But will he really make this???

Load Images To View Load Images To View

 

Lesson Sixteen - Part B: What If You Scale Out???

Many of the same schools that teach you to monitor your risk to reward before you take a trade also teach you to scale out of your trade. After all, they say, if your trade is becoming profitable but doesn't quite work out to give you the full 60 pips, you should at least walk away with some profit to show for the trade, right?

Let's take an example of a trader who has done just that and see what his results are. This trader used the 0.92 standard lots that his Calculator showed him to be the correct position size for his chosen risk profile. He sold the EURUSD at 1.3291.

A few minutes later his trade was looking good and he had 16 pips showing as profit. He decided to close a little less than half his position, 0.4 lots, and let the rest ride to see if it could make full profit.

About 20 minutes later his trade now held 31 pips in profit. He was feeling good, but didn't want to see that profit slip away, so he closed out 0.2 lots and left the remaining 0.32 to ride.

Over 40 minutes later, and Wow! He's sitting on 46 pips. Great. He closes out another 0.2 lots.

Finally his last portion of the trade hits his take profit. Whoopee!!! 60 pips. He did it. The trade worked perfectly.

This is how his trade will look in the Forex Smart Tools Trade Log because he uses the feature Allocation Breakdown to easily group all 4 legs of this trade into one.

Load images To View This

So having made 60 pips, did this trade end up yielding a 2 (i.e. 1: 2) risk to reward, as he had planned?

 

Lesson Sixteen - Part C: Working Pips

Not at all!!! In fact, this trade gave him only 1.066 reward for his risk. Here's the invaluable and yes, amazing display that the Forex Smart Tools Trade Log now shows him for this four-leg trade:

Load images to see this

The concept we want you to really understand is the term that we have created called WORKING PIPS. Here is a zoomed-in detail of the Trade Log display:

Load Images to view this

Because of how this trader scaled out, he only got the working power or juice out of his trade that he would have achieved if he'd let his whole original position size go to 32 pips. In other words, if he'd let his 0.92 lots go 32 pips, he would have made $290. This is how much he ended up actually making as the result of having scaled out in four legs. Remember his original risk going into the trade was $276, so he risked $276 to get $290. That's a ratio of 1 : 1.066.

This is a generous example we've created to show this in action. There are actually many times that traders scale out and end up getting far fewer pips than they put at risk.

For example, let's say our same trader put on his 0.92 lot trade and hit half his goal: 30 pips. He scaled half of his position out (0.46 lots) and left the other half to ride. He put the remaining half of his position to break even and went to sleep, hoping it would hit his 60 pip target. Instead it stopped out at break even.

How many WORKING PIPS did he make? 15. In other words, he risked 30 pips to actually make 15 working pips, so his risk to reward ended up being 0.5. What's important to see is how differently this ends up from the 2.0 that he planned. Just because you plan one thing, doesn't mean you get that - even if your trade looks like it goes to full profit.

You don't have to do the math about this of course. The Trade Log will do it for you. But you should understand the concept behind this idea, because it is crucial to making money in Forex.

For those of you who own the Forex Smart Tools and thus have access to our Money Management webinars in the Video Library, you can watch the two movies "What's Important To Record About Your Trades: Flash – Splash – Cash" and "The Best Way To Record Trades: What You Should Track" to learn more about these ideas.

We'll be discussing more about risk to reward, and how to evaluate if you can be making more money from your current trades than you perhaps are, in future volumes of the Newsletters as well.

Risk Disclaimer

Before deciding to participate in the Forex market, you should carefully consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose.  There is considerable exposure to risk in any off-exchange foreign exchange transaction, including, but not limited to, leverage, creditworthiness, limited regulatory protection and market volatility that may substantially affect the price, or liquidity of a currency or currency pair.  Moreover, the leveraged nature of Forex trading means that any market movement will have an equally proportional effect on your deposited funds. This may work against you as well as for you. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position. If you fail to meet any margin requirement, your position may be liquidated and you will be responsible for any resulting losses.