Last Updated on
I’m sure all of you have heard this term Risk to Reward Ratio in trading. This term is so grossly overused by most traders.
They usually say you should aim for a minimum of 1 to 2 risk reward ratio. In other words your profit target is twice your stoploss or you stand to make $2 for every $1 you risk.
If that’s the case then I can simply long Eurusd at 1.3900 with a stoploss of 10 pips and set a profit target of 1.4900. Wow risk to reward of 1 to 100! I should take this trade!
But what most traders forget is to assign a probability to the risk reward equation.
Instead it should look something like this:
(Probability of losing * Pips stand to lose) to (Probability of winning * Pips stand to gain) – (Spread + Commission)
Risk to Reward is meaningless if you don’t assign a probability factor to it. If you have a 90% probability of making $5 for $10 risked, then you should take the setup over and over again.
But wait! Traditional dogma says the risk reward is less than 1 to 1, so it’s a bad trade.
In trading it is easy to be filled with information paralysis. Always question and think for yourself because no one will spare a thought for your trading account.
Best of luck!