Risk and reward ratio

One of the worst errors novice investors can make when entering a trade is not knowing when they will get out of it. While they may be confident because of their previous success in the context of demo trading, not setting a limit or (especially) a stop order can often lead to disastrous consequences.

The Importance of Stop and Limit Orders

Trading in a live account is indeed very different experience from a demo account, since emotion and psychology will play a huge part in a trader’s strategy, often leading them to bad choices, such as that of closing losing trades too often or not to close earning trades at all in an attempt to get the most out of them.

For this reason, it is very important to set at least the two thresholds of stop and limit orders, which enable traders to immediately see what the best and worst possible outcomes of a trade are, allowing for a much more effective management of one’s assets.

How to Set Stop and Limit Orders: Risk/Reward Ratio

Knowing that traders need to set stop and limit orders is certainly a big step forward, but they may still need some guidance as to how to set them relative to one another. An often cited parameter in these circumstances is the risk/reward ratio (sometimes referred to as reward/risk ratio), which simply expresses the quotient of maximum loss and maximum gain from a single trade.

Many experienced forex traders use the risk to reward ratio to correctly set their stops and limits. In fact, most of them will consistently set them so to have a reward/risk ratio that is greater than one, which means the possible gains are typically twice or three times the maximum losses.

The reason behind this choice is that, since even the most experienced traders can make mistakes, it is important to stop losing trades relatively soon, while letting profits flow until the current trend reverses.

This way, assuming a hypothetical trader is alternatively gaining and losing a trade, his overall trend will still be a positive one — conversely, if his reward-to-risk ratio is less than one, he will lose in the long term under the very same market conditions.

Drawdown in Forex

Setting stops and limits correctly is very important, but the risk-to-reward ratio doesn’t provide us with all the elements we need to this regard. In fact, traders need to express their risk factor relative to to their total assets as well, to make sure they won’t lose a high percentage of their accounts on a single trade.

For this reason, many experienced traders will use a correct risk/reward ratio in conjunction with a stop loss that makes sure their maximum loss from a single trade is below a predetermined percentage of their total assets — such percentage usually varies between 3-5% of the trader’s equity.

The reason why this percentage is relatively low is that losing a big part of an account is increasingly hard to patch up. For instance, if a trader was to lose 50% of his/her account on a single trade, going from $10,000 to just $5,000 as a result of a single poor choice or an unexpected market move, he/she would have to earn back 100% of his/her current assets to get back to the initial position. This is commonly referred to as drawdown.

Learning to take control of your risks is straightforward and should be part of every trader’s strategy: those who don’t make use of correctly set risk-to-reward ratios are in fact often considered too aggressive to be consistently profitable.

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