Lately I’ve been answering alot of questions about reward/risk ratios, it’s also part of the money management strategy taught in Forex Sailing.
Today I’m going to go a little deeper into this topic because it’ll help you understand online forex trading better.
Any time you place a trade, you should set a stop & limit. If you take the pips you will GAIN (if the trade goes well) and DIVIDE by the pips you can LOSE (if the trade fails), you get the REWARD/RISK Ratio.
This ratio gives you a percentage so you can understand the risk of the trade in a standard way.
Once you know the Reward/Risk Ratio, you can determine what percentage of the time you need to be correct to breakeven. If you’re right more than that you’ll make money. If you’re wrong more than that, you’ll lose money.
Let’s look at an example:
You find a Forex Sail. You determine that if you place a 100 pip stop and a 170 pip limit, you’ve got you’re trade. If you DIVIDE your potential REWARD by the total RISK you get 170/100 = 170%.
If we did many trades, here’s how we could breakeven:
- Lose 100 pips 170 times = 17,000 pip loss
- Gain 170 pips 100 times = 17,000 pip gain
- Loss = Gain = Breakeven!
In this example there were actually 270 trades. We broke even when we were profitable on 100 of them. If we divide 100/270 (WINNING # of Trades / Total Trades) we get the BREAKEVEN PERCENTAGE.
In this case 100/270 = 37.04% is the BREAKEVEN PERCENTAGE
More About the Breakeven Percentage
If our trade works out more often than the BREAKEVEN PERCENTAGE we’re profitable as traders. In the example above we need to be right more than 37.04% of the time with that Reward/Risk Ratio…
Sounds good, doesn’t sound too hard to be right a little more than 1/3 of the time, right?
There is kind of a catch…a tradeoff really…
Breakeven Percentage Catch-22
The lower the breakeven percentage, the MORE LIKELY you are to be unsuccessful with your trade!
In our example the stop is much closer than the limit. Think about that for a minute…
If your stop is closer than your limit, you’re more likely to get stopped out, right?
The opposite is true. If the limit is closer than your stop, you’re more likely to hit the limit first.
Breakeven Percentage Chart
I’ve created a chart below with a few examples so you can see the pattern of Reward/Risk Ratios & Breakeven Percentages.
When reward = risk, you only need to be right half the time (50%) to breakeven (beige). This is common sense.
If reward < risk, you have to be right more often (light blue).
If reward > risk, you can be wrong more often (purple).
What Does This Mean?
In my next blog post I’ll be sharing more of what this means for making online forex trading decisions. For now, just think about the Reward/Risk ratio, and don’t make a trade without knowing what it is!