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When we examine the reward-to-risk ratio, we can see that the second methodology besides being three times more risky in terms of drawdowns, also has a terrible reward-to-risk ratio. It makes little sense to risk $1 when the potential gain is limited to $1. The first methodology is risking $1 to have the potential gain of $3. |
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The vast majority of novice traders fail to adequately look at reward-to-risk ratios. A lot of successful traders are profitable, yet they lose on 60 percent of their trades, winning only 40 percent of the time. The question then arises: If the majority of the times they make a trade they lose, how are they profitable? The answer logically is that when they do win, they win enough to make up for their losses by a healthy percentage. Consequently excellent traders strive to create a methodology that can generate a profit objective, commensurate with where their protective stop would have to be. |
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In addition, as traders look at various markets and perceive different profit opportunities, they can rank the viability of the various trades by their reward-to-risk ratio. In order to pay for their losing trades, traders must look for the trades whose profit potential exceeds the probability of losses. They do so by ascertaining the profit potential in a particular trade, and the correlated risk. The most commonly used ratio among professional traders is a reward-to-risk ratio of 3 to 1. In other words, while monitoring the various trading opportunities the market is presenting to them, these traders look for a trade that will allow them to risk losing $1 with the probability that they will earn $3. This strategy then allows them to use their capital most effectively. |
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A reward-to-risk ratio should be based on probability, and successful traders are confident that the probabilities will always come back in their favor. In other words, if a system or methodology demonstrates that the probability of success is greater than 50 percentsay, 65 percentthen 6.5 times out of 10 the trader will win, meaning that losses will occur only 3.5 times out of 10. The art of structuring risk is to recognize that sooner or later the probabilities will come back home; you'll lose those 3.5 times out of 10, and will need to have that amount of drawdown as your risk capital. This is especially true if that 3.5 times out of 10 comes one after the other! |
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A critical distinction needs to be made here. That distinction is how important volume (or the number of trades a trader makes) is to synthetically create those odds. For example, flipping a coin 10 times may not yield a 5050 split, but flipping it 1000 times will. Therefore traders need to have |
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