Using the Risk/Reward Ratio to Be More Profitable

An extremely successful way to determine exit points is to look at the risk/reward ratio on a trade. Applying the risk/reward ratio provides a pre-set and well calibrated exit points. If the trade doesn't offer a favorable risk/reward, then the trade should be avoided, which helps to eliminate any low-quality trades from being taken.

If the target is reached on a trade, then the position will be closed, and the target priced according to the strategy in place. If the stop loss is reached, then the manageable loss will be accepted, and the trade will be closed before it has the opportunity to become a larger loss. With this, there isn't any confusion regarding what to do, an exit has been planned for the predetermined exit points, regardless of if it is unprofitable or profitable.

If the trend is up during a trade, then buying during a pullback is recommended. In some cases, waiting for the price to consolidate for several bars or candlesticks, and then buying when the price exceeds the high of consolidation is best. The difference between entry and stop loss is significant enough to see, making it possible to know what to do, and when.

In theory, the risk/reward model is both effective and simple. The real challenge occurs when a person tries to make it work altogether. It doesn't really matter how good the reward:risk is if the price doesn't ever make it to the profit target. A quality target, that has a favorable risk/reward will also require a quality entry technique. The stop loss and entry will determine the risk portion of the equation, so the lower the risk is, then the easier it will be to have a more favorable risk/reward scenario. Note that the loss shouldn't be so small that the stop loss is triggered unnecessarily.

While this may sound confusing, it is easier to understand with a real-world scenario. Assume that you are making a swing trade and purchase a currency pair with a profit target of 60 pips. Then, a reasonable the stop loss is set at 25-30 pips. In this case, only 25-30 pips just above or below your support or resistance levels, will give you a 2 to 1 reward to risk as a realistic expectation.

The actual calculation of the risk/reward ratio is contingent on the currency pair that is being traded and, due to the many pre-existing variables in the calculation of the pip value for a trade, it is easier explained with stocks to use a fixed value. If you enter a trade for a stock that is priced at $50 USD, your target is $55, and your stop loss is set at $1, the stock will only have to move by 10 percent to reach the $55 mark, or two percent to reach the stop loss, which creates a 5:1 reward:risk.

Depending on market conditions and the economic calendar, there are quite a few currency pair that will move by 10 percent in just a week or two. I would never set a trade with a 1/1 risk/reward ration and would always go for a 2:1 or a 3:1 reward:risk. This means a bigger move is needed to achieve the target, but makes the risk worth entering the trade.

To be successful, a trader have to find a setup that helps to produce a high risk/reward ratio. However, it is necessary to have a relatively conservative price to produce the desired ratios.

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