Risk to reward ratio is determined by comparing the distance from your entry point level to your stop loss level to the distance from your entry point level to your take profit target point.
It can also be termed as how much you are willing to expose to the market to how much you expect to make from the market for each trade you take.
Stop loss is measured from the entry price subtract the stop loss price.
Take profit will be the target price level of exit minus the entry price.
Let’s look at an example below with small channel breakout to downside;
The signal for the Sell entry was candle close below the channel trendline support.
Risk is measured from the entry price to the stop loss price and reward is measured from entry price to the target/ exit price level.
Risk reward ratio is the amount of risk divided by the reward.
Juat like we mentioned previously, It can also be termed as how much you are willing to expose to the market to how much you expect to make from the market for each trade you take.
For instance, if I want to risk 1% of my $3000 account per trade, planning to make 3 times my risked money. this simply means am aiming at a risk reward ratio of 1:3.
This simply means, If the trade goes against me, I lose 1% of my account and if the trade is to my favor make 3% of my account i.e 3 times the amount I have risked.
Understanding the risk reward ratio and how it applies to each trade will improve your trading.
The kind of ratio you choose to use should be in line with the probability rate of success of your trades so that you are able to assess if the trade is worth taking or not.
With the entry point, the risk can be set using the stop loss target level so that when a running trade reaches that level it automatically closes out and would be taken as a loss while to determine your reward set a target profit level that will closes the trade automatically when price level is hit .
Before taking any trade, first ask yourself these questions and if you have ready answers, you can go ahead and take the trade.
- Where is the entry point for the trade? Have I identified the entry? If yes,
- Where do I put the stop loss?
- Where do I put my target profit?
- What is my risk to reward ratio?
When you calculate your risk reward ratio, you will be able to decide whether the trade is worth taking or not. If the trade give great ratio according to your plan, you can go ahead and take the trade if not just skip the trade and wait for another set up.
Always set targets that are more reasonable and attainable so that you are able to increase on your chances of success and still able to cover up your losses even if the number of times you lose are more than the number of wins.
When we say your take profit target should be bigger than your stop loss doesn’t mean that you have to make your stop loss very tight next to your entry point and your take profit very wide. Your stop loss should give enough room for the market to breath.
In the later lessons, we will learn how to set appropriate stop losses while keeping the reward large enough.
Looking at your system’s performance you should be able to tell what risk reward ratio is tolerable in your plan. It could be 1:1, 1:2, 1:5 etc but atleast keep it at a minimum of 1:2
This can be achieved by testing your system as many times on a demo and makings journal to assess the performance and degree at which the setups taken have been able to hit your stop loss or take profit targets. There you will be able to know if what risk reward will be successful in your trading.
Risk to reward ratio can be adjusted depending on the trading range, time frame and your entry and exit points.
How long you should hold an open position, is a personal thing for all traders. The decision is all yours. You know what your goals are as a trader, the kind of strategy you use to trade. All this starts from what you are? and What you want? If I am to answer, this...
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