Setting up an advantageous reward to risk ratio is an overlooked aspect in trading, but one whose importance is critical in establishing yourself as a successful trader.
Typical retail traders will often look at their “winning percentage” as an important metric. Most traders would dearly love to be able to say they can pick 70% or 80% winners. After all, it seems logical to say that if you win more than you lose, you should be profitable. Most will also say that they’d be happy to break out even in terms of money won or lost if they’re running 50% winners.
The facts are, however, that few if any traders can maintain a 70% to 80% winning percentage over time. But don’t let that discourage you because I’ll show you that there’s a way to be profitable by winning just 33% of the trades you enter (or even just 25%)!
It all comes down to entering trades where the risk is greater than the reward. The lower the winning percentage you can make a profit with, the greater the odds are that over time, you’ll be profitable. In other words, it’s the trader with the lowest profitable winning percentage that truly has the advantage. Let’s take a look at the numbers.
If you risk 30 pips on a trade that can return 90, you’ve set up a 3:1 reward to risk ratio. If you lose 2 of these trades and win just 1, you’ll still be 30 pips ahead of where you started because while you’ve lost 60 pips on the 2 losers, you’ve gained 90 on the 1 winner. In other words, a winning percentage of just 33% has got you nicely ahead of the game!
On the other hand, let’s say you set up a trade where you risk 30 pips to win just 20 which, believe it or not, is how a lot of people trade in reality even if they don’t set it up that way in the first place (how many times have you traded with a 25 or 30 pip stop and then was happy with the profit after 15?). In this case, you have a 2:3 reward to risk ratio which in this example means that even if you win 3 out of your next 5 trades (60%), you’ll still be just breaking even!
The key to being able to do this is to do what every trader knows-in a long trade for example, you want to buy low and sell high. Buying low means two things. First, you want to buy at a price as close to possible to where you’ve recently seen buyers come into the market because it’s essential that, for a long trade, that you not allow yourself to get stopped out where buyers have recently been. Second, the point at which you buy must be far enough away from a logical target so as to set up an advantageous reward to risk ratio. In other words, you have to set a target at a price where you’ve seen buyers recently go to so that you’ll have a chance to “sell high” after you’ve “bought low.”
In the second part of this article, I’ll show you some chart examples of what I mean, and I’ll show you how to make a judgment as to where logical entries and exits are based on recent price movement.