Just how do you figure out what are acceptable levels of risks and rewards in trading? That’s a tough question to answer, because it’s a lot like asking someone how many layers of clothing you might need to go play outside safely on February 26th in Boston. If you check the annual weather report, you see that the temperatures and weather can vary widely, even on this winter date alone. Some years, a sweater might be enough, but others might require a heavy winter coat and head covering.
Trading is a lot like the weather, in that it is not an environment known for accuracy, but is infamous for its significant volatility. So, any debate about risks and rewards is always linked to the moment in question. A very conservative and often touted view regarding risk and reward is to use a ratio of two to one. This is where you would risk roughly half the pips you hope to make; essentially, if your profit target is 50, then you put in a stop level of 25.
That seems like sound strategy on paper, since you’d only need to be correct about forty percent of the time in order to profit. On the other hand, most actual traders don’t personally practice this idea. Plenty of gurus, coaches, teachers, analysts, so-called experts and individuals labeled strategists have all advocated this technique, but if you look into them, you’ll find that most have not even gambled their lunch money on any trade. The two to one idea just isn’t used by those in the trenches actually squeaking out a living trading.
Why is this?
The secret behind this is that folks who don’t actually trade never have the chance to learn for themselves that there’s really nothing in the market that could be considered actual reward. Only risk awaits traders. Markets aren’t like vending machines where you punch a few buttons and then get a set product or profit from the situation. In fact, markets do all they can to upset the goals and aspirations of traders. Consider a situation where you put 50 points into play, hoping to score up to 100. The trade might start off going how you want, as the floating p/1 rockets up and gets to 98 or so. If you’ve burned the two to one ratio into your mind, you sit there waiting for 100 so you can go make another trade. Guess what happens? A market stall shows up suddenly, followed by a reversal. Your spirits drop as the markets do, as your trade does too, falling all the way through your stop. What did you lose? You might first say 50 points, but in truth, you lost 148 from the combined 50 on your stop and the -98 you never booked. This just goes to show how the two to one ratio just doesn’t work in the real world.
The truth of the situation is that you can not forecast market profits. The only factor that you actually have any personal influence over is the factor of risk. This is why trading is always done with a pair of units, not one. This is why traders go after short first targets, and why they trail their stops to aggressively manage risk. It’s not pretty, but it’s the only assured way of successfully managing both risks and rewards when trading on the markets.