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Trading Risk Reward Ratio And How To Manage It Properly
We’ve got a great question here from Brian in the followup to our previous question, or video about the stop-loss placement saying that if we sometimes do use that second swing point, won’t that give us a very bad or negative risk-reward.
Now Brian, excellent question yeah, and we can use today’s NCD CAD as a good example of this. So, based on the usual way we approach our stop loss placement based on that previous video, we would’ve looked, probably look, for a stop loss below this overall first swing, not the second today.
RECOMMENDED READING: HELP WITH TRADING RISK REWARD RATIO
The reason for that is well within that ADR and range, it’s below the ADR low. It’s also below that swing point and it’s also below the 84 50 psychological level. So, all in all, a proper stop-loss to take.
But looking at the reward or the profit target, if we assumed an entry in this area and we take it off somewhere in this resistance zone, that would give us the– a negative risk reward. But remember that when we placed or chose this resistance era, we looked at all the technical information at hand.
We had the most recent fair value area. We also had the psychological 85 50. And we also had the ADR high. So based on the probabilities of of using this zone as a target, that would have given us a negative risk reward for this trait. Now, based on risk reward methodology, we can handle this in three ways, right?
Firstly, we could reduce our stop loss, but if we do that, we drastically decrease the probability of this trade working out because we increase the probability of the stock loss to be getting hit even though the most probable place to place it is below this swing.
Secondly, to make the trade fit into the risk reward, we could increase our profit target. But, if we did that, again, we’re not using the most probable areas for our profit target.
Now the third option of course, to make my trade for into the risk reward, is by simply not taking the trade at all because based on the highest probability areas in the chart, that trade does not make sense from a risk reward point of view. Now the challenge of all three of these options, right, is that in each one I’m trying to make my trade fit into the risk reward, which means that the risk reward is dictating the probability of the trade and not the sentiment that’s currently driving the market.
Secondly, it also assumes that you will always exit your trade at your preset stop-loss level, right?
So, like a mechanical enter and exit, it assumes that you will never do any type of trade management. So if we always allowed a trade to be closed with the stop-loss, then risk reward makes a lot of sense.
Which is why purely technical strategies is very white, very important for purely technical strategies, but we are not allowing each trade to get closed at the initial stop loss, right? We use a dynamic stop, which basically just means that we do trade management. That means the moment, the reason for entering the trade has changed– the reason for the trade has become invalid, we basically just close it out immediately.
Whether that is at breakeven, whether that is at a stop loss, a small loss or a small profit. The moment the sentiment changes we’re out. Now, like we said in the previous stop-loss video, we rarely let a full stop loss get hit because if the sentiment changes, we just close the trade out immediately.
That is why we use a designated area for profit targets as well because we want to see how price reacts when it reaches that level. We’re not just blindly, you know, closing it out. They want to see where the strong enough sentiment to maybe carry on.
But that is usually the highest probability area for us to consider taking it off. But you know, if we are halfway to our target, later we enter a year and we’re somewhere in this overall area, if the sentiment changes, we just get out of the trade immediately without thinking twice. We’re not going to allow that stop to be hit.
In the same way, as price starts to move in our favor in a particular trade, it’s always a good habit to do a trade management to reduce your risk on that particular trade by making sure you move your stop loss up as the price moves up. So, in this example, as we moved up, we could’ve, you know, moved our stop either below the level this– this overall swing below the actual swing up here, or maybe even to break even as the price started to move in our direction.
So in that sense, the only reason why you are anchoring your stop the way that we do is by allowing it room to move. And also, you know, to– to– to get your analysis in case you get your analysis splendidly wrong, or there’s a massive volatility event that occurs unexpectedly, at least you protect your account from a massive spike.
But that happens, you know, that– that happens very seldomly. And if that happens on a very every day with all of your trades, then you’re not trading in line of the sentiment, right? Because if you trade a lot of the sentiment, for the most part, the market should be moving in your direction.
Now, just to be absolutely clear at this point, as far as it is possible, we will always want to risk less than our potential reward, right? It’s not an inherently bad thing. We should always strive for ratios.
Let me just say that one more time. We agree that having positive risk reward ratios are a good thing, but using sentiment to dictate your trade direction and using a dynamic stop-loss with a good trade management, with ideology, it gives you a much better and higher probability of closing more trades for winners than just purely looking at that one to one or hard one to two a limit in terms of risk reward.
So yes, we always want a positive risk reward, but if I look at a trade like this and I get less than a one to one, I still consider this a higher probability opportunity because I’m trading in line with the sentiment firstly, and secondly, I’m not going to leave my stop hanging around here.
The moment this trade moved up, I did move my stop up and to a much more attractive level. And as we hit goes into that target, you know, manage that trade, move it to break even. And as it reach into– reach that zone close out for a profit.
You do need use dynamic a stop loss or trade management, as a, you know, to increase your probability of wins. So I hope that makes a lot of sense in terms of risk reward.
So yes, it is important, but the overall sentiment and the way we managed rates, and for us, it’s much more important than just using a hard one to one or one to two, or one to three risk-reward ratio.