Consider the old adage permeating the forex market that a trader must maintain a ratio of two dollars in potential profit for every dollar that is risked on a transaction.
Is it true? Does a 2:1 profit/loss ratio matter?
The first thing to recognize is that a successful trader is measured by profitability, not maintaining an industry-expected risk reward. Trading manuals and Forex gurus have long trumpeted the 2:1 risk reward ratio as a guidepost for traders. Traders in turn march dutifully to the mantra of 2:1 risk reward ratio.
Let's look at some examples in the forex market to test the traditional wisdom.
Trader A has a taste for risk in her trading style and accepts a healthy $400 average loss. But she is making an average of $800 on her winning trades - an "admired" 2:1 risk reward. But her winning percentage is only 30%. For every 10 trades she thus loses an average of $40, despite her 2:1 risk reward that is widely advocated.
Trader B, on the other hand, makes an average of only $175 on her winning currency trades but still endures a $400 average loss - a frowned-upon risk reward on 1:2.29. Yet she makes a gain on 70% of her trades. For every ten trades she makes she realizes a profit of $25.
What is at work here is not the risk reward ratio that is determining profitability but the risk reward ratio operating in tandem with winning percentage. It is the expected win percentage AND the fundamentals of the risk reward ratio that must be continually evaluated.
When playing the forex market traders must determine the style of trader they are, not blindly pursue industry-recommended ratios. Once a calculation is derived to tag your win percentage as a trader, then you can figure what risk reward ratio is needed at a minimum to make a trade pay off.
Traders with lower win rates must make sure their trades average larger risk rewards to deliver bottom line profitability. Others who are not willing to take large hits for a big score will push their trading activities towards a higher win rate and smaller risk reward ratios.
Too often trades are labeled a good play if they present rewards two and three times the money risked. But what if the trade has a success rate of only 10%? Who is going to make that "good" trade now? On the other hand if your research shows a statistical edge that provides a 90% win probability what will it matter if you are trading with a 2:1 risk reward or a 1:5 risk reward? Trading in the forex market can't be executed in knee-jerk fashion based on accepted ratios born in an informational vacuum.
There are many roads to success in the forex market but one road is pitted with more potholes than the rest - following traditional wisdom.
Is it true? Does a 2:1 profit/loss ratio matter?
The first thing to recognize is that a successful trader is measured by profitability, not maintaining an industry-expected risk reward. Trading manuals and Forex gurus have long trumpeted the 2:1 risk reward ratio as a guidepost for traders. Traders in turn march dutifully to the mantra of 2:1 risk reward ratio.
Let's look at some examples in the forex market to test the traditional wisdom.
Trader A has a taste for risk in her trading style and accepts a healthy $400 average loss. But she is making an average of $800 on her winning trades - an "admired" 2:1 risk reward. But her winning percentage is only 30%. For every 10 trades she thus loses an average of $40, despite her 2:1 risk reward that is widely advocated.
Trader B, on the other hand, makes an average of only $175 on her winning currency trades but still endures a $400 average loss - a frowned-upon risk reward on 1:2.29. Yet she makes a gain on 70% of her trades. For every ten trades she makes she realizes a profit of $25.
What is at work here is not the risk reward ratio that is determining profitability but the risk reward ratio operating in tandem with winning percentage. It is the expected win percentage AND the fundamentals of the risk reward ratio that must be continually evaluated.
When playing the forex market traders must determine the style of trader they are, not blindly pursue industry-recommended ratios. Once a calculation is derived to tag your win percentage as a trader, then you can figure what risk reward ratio is needed at a minimum to make a trade pay off.
Traders with lower win rates must make sure their trades average larger risk rewards to deliver bottom line profitability. Others who are not willing to take large hits for a big score will push their trading activities towards a higher win rate and smaller risk reward ratios.
Too often trades are labeled a good play if they present rewards two and three times the money risked. But what if the trade has a success rate of only 10%? Who is going to make that "good" trade now? On the other hand if your research shows a statistical edge that provides a 90% win probability what will it matter if you are trading with a 2:1 risk reward or a 1:5 risk reward? Trading in the forex market can't be executed in knee-jerk fashion based on accepted ratios born in an informational vacuum.
There are many roads to success in the forex market but one road is pitted with more potholes than the rest - following traditional wisdom.
Editors’ Picks
EUR/USD climbs to daily highs near 1.1820
EUR/USD now picks up pace and advances to the area of daily peaks north of the 1.1800 barrier at the end of the week. The pair’s decent move higher comes against the backdrop of a generalised lack of direction in the FX galaxy and the mild offered stance in the US Dollar.
GBP/USD trims losses, retests 1.3460
After briefly challenging its key 200-day SMA near 1.3440, GBP/USD now manages to regain some balance and revisit the 1.3460 zone on Friday. Cable’s pullback comes as the selling pressure on the Greenback gathers traction, reigniting some recovery in the risk-linked space.
Japanese Yen gives back half of early gains against USD ahead of US PPI data
The Japanese Yen (JPY) surrenders half of its early gains against the US Dollar (USD) during the European trading session on Friday. The USD/JPY pair rebounds to near 155.90 as the JPY falls back, but is still 0.15% down.
Editors’ Picks
EUR/USD: Fed calm, ECB steady, but the Dollar still leads Premium
EUR/USD is still struggling to find real traction. The pair has tried to stabilise, but momentum keeps fading, leaving the door open to further weakness.
Gold: Falling US yields, geopolitics help XAU/USD hold ground Premium
Gold (XAU/USD) gained traction and climbed above $5,200, ending the fourth consecutive week in positive territory. The next round of US-Iran talks and crucial macroeconomic data releases from the US will be watched closely by market participants in the short term.
GBP/USD: Will Pound Sterling defend key 1.3450 support ahead of US jobs data? Premium
The Pound Sterling (GBP) entered a bearish consolidation phase against the US Dollar (USD), after having tested critical support near the 1.3450 level on several occasions.
Bitcoin: Another month of losses, and it’s been five
Bitcoin (BTC) price is stabilizing around $68,000 at the time of writing on Friday, but the Crypto King is poised to close February on a fragile footing, marking its fifth consecutive month of losses since October and a rare start to the year with back-to-back monthly corrections.
US Dollar: At a crossroads; Fed steady, tariffs in flux Premium
The US Dollar’s (USD) upward momentum from the previous week seems to have encountered a tough nut to crack in the 98.00 region, as measured by the US Dollar Index (DXY).
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