forex #16

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Risk-to-Reward Ratios: How to Trade Like an
Insurance Company
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Trading in the FOREX market is a challenging opportunity
where above average returns are available to educated and
experienced investors who are willing to take above average
risk. However, before deciding to participate in FOREX
trading, you should carefully consider your investment
objectives, level of experience and risk appetite. Most
importantly, do not invest money you cannot afford to lose.


In Lesson #13, we spoke extensively about Equity Management
and Margin Control. In today's lesson, we want to cover some
basics about how you can you effectively put the odds (of
continuing to keep your account equity in the positive and
make nice returns) in your favor even if you're "right" only
50% of the time.


Why do insurance companies consistently win? Insurance
companies are consistently profitable because they use the
laws of mathematics, probability and "special circumstances"
to their advantage. They can pick and choose whom they want
to insure and the price they want to charge for insurance.
Therefore, they "own" the game by being able to call the
shots and rates that we must pay to enter into their playing
field.


Research shows that older smokers tend to have high
mortality rates. Therefore, the insurance companies charge
excessive premiums for these types of people; while young
healthy people tend to be the best risks, so lower rates are
charged as the probability of paying a premium to this
person's family is relatively small. This is not a level
playing field, as the insurance company makes the rules and
requires the charges to be paid.


Do the same with your trading. Here's how:


First, look at the following table. It shows possible risk-
to-reward ratios and the win ratios (the percentage of time
you need to be "right") required to BREAK EVEN with a
trading system, method or strategy.



Risk-to-Reward Ratio Win Ratio
(in pips) Required to Break Even
------------------------------------------------------
40/20 (2:1) 67%
40/40 (1:1) 50%
40/60 (1:1.5) 40%
40/80 (1:2) 33.5%
60/20 (3:1) 75%
60/60 (1:1) 50%
20/30 (1:1.5) 40%
20/40 (1:2) 33.5%
------------------------------------------------------


If you were to toss a coin (heads you go long, tails you go
short) you'd have a 50/50 chance of winning or losing (your
trade can only be profitable or unprofitable. The market can
only go with you or against you). If you were to trade with
a 1:1 risk-to-reward ratio, then after a hundred trades you
should theoretically have around the same amount of money
left in your account (break even as shown above).


To manage risk effectively, it is necessary to find high-
probability trades that have a 1:1.5 or greater risk-to-
reward ratio. But this depends largely on the timeframe you
are looking to trade.


For instance, in our book "Rapid Forex Surfing", one of our
trading techniques teaches you how to go after 20 to 40 pip
trades and use a 1:2 risk-to-reward ratio. So, for instance,
you would set your reward for 40 pips and your stop-loss
order for 20 pips (20 pips below the entry order). While
statistically the odds start working against you for winning
this trade, you can shift the odds in your favor by using
"high probability" strategies. Let's say you try out the 1:2
ratio on all your trades for a while. And lets say you're
only right 50% of the time (though you should be able to do
better than that). Meaning half of the trades you win and
half you loose (they hit your 20 pip stop). So, if you made
4 trades, and assuming 2 of them won and 2 of them lost,
then look at what happened. You made 80 pips (2 x 40 pips)
and lost 40 pips (2 x 20) for a net of 40 pips.


In Lessons #7 & #8, we talked about the need to identify
potential trades based on chart patterns. The idea is that
you collect a set of candidate charts, charts that have
positive prospects for immediate trading. It is with these
candidate charts that one can dig deeper into the possible
trading of a particular currency pair. The identification of
a probable trade centers around the proper identification of
realistic entry and exit positions based primarily on
support and resistance. Once you have properly identified
the support and resistance points you can take those
numbers, plug them into a simple spreadsheet and calculate
the risk / reward. The simplest form of calculation involves
nothing more than the following:


- Entry Price
- Stop Loss Target
- Stop Profit Target
- The resulting Risk-to-Reward Ratio


Here's an example of a trade that we were looking at
recently. For clarity, let's follow the logic of the
simplest risk/reward calculation one can make:


Currency Pair: EUR/USD
Type: Buy
# of Lots: 5
Entry Price: 1.3320
Stop: 1.3300
Target: 1.3360
Loss Risk: $1,000
Profit Potential: $2,000


To see if the potential play is worth wagering money on, one
must determine what the potential losses are if your
analysis is wrong and what the potential gains are if the
analysis is correct. You should usually shoot for a 2:1
ratio - that is your potential profit should be roughly 2
times your potential loss. This is a rule of thumb that many
traders use ... especially the good ones. In the example
above, if one enters a trade at the price of $1.3320 with a
defined stop loss exit of $1.3300 and a potential target
exit for profits at 1.3360, then the ratio is roughly 2:1 (a
bit less in this case, when you take into consideration the
small broker pip spread). That's it. It's really that
simple.


Recognize that once one has entered such a formula into a
spreadsheet and begins using it, one can easily play with
the numbers to make them work. For example, let's say that
EUR/USD looks like a great BUY right now, but that the exit
is really $1.3370 not $1.3360. Now, one could stretch the
target to $1.3390, even though the resistance lies at
1.3380, in order to justify the trade, but the trader inside
you knows this is not the case. When setting support and
resistance points, one has to realize that if the numbers
are fudged, the person fudging the numbers is the one hurt.
It's their money that's on the line.


An easy way around the temptation of making the numbers
work, is to always look at the support and resistance points
first and allow as much slack in the numbers as makes sense.
Now, plug in the entry price. Does the risk/reward make
sense? If it doesn't, change the entry price, not the stop
or target prices. Jiggle the entry price to the point where
it makes sense and then simply wait until you get that entry
point or pass the trade up. There are always more fish in
the pond.


Ending Thoughts on this Lesson:


Always calculate your risk to reward ratio prior to making a
trade. Refuse potential trades unless the risk-to-reward
ratio is at least 1:1.5 or greater (preferably 1:2): that is
for every dollar risk, there is a potential for 1.5 dollars
in return. By calculating your risk to reward for every
trade you will ignore marginal trades and you will identify
your exit points before taking a trade. Recognize that you
want to understand your exit criteria ... at the beginning
of the trade, not sometime later. Once you are comfortable
with simple risk to reward measurements and are identifying
support and resistance zones reasonably accurately (see our
book "Rapid Forex Surfing"), you can consider increasing the
complexity of your formula to consider other variables such
as time and confidence.