Tuesday, November 03, 2009

Emini Futures Trading - The Myths about Risk-to-Reward Ratio / Tuesday November 3rd, 2009


Myths about Risk-to-Reward Ratio
Recently we sent out an e-mail report entitled "Are you using Risk Management?" In that report we touched on a number of principals regarding risk management that we believe every trader should apply to their trading. In this segment, we will address the principal of Risk-to-Reward Ratio, along with common misconceptions regarding this concept.
Classic Definition of Risk-to-Reward Ratio
The risk-to-reward ratio is simply a calculation of how much financial risk is involved in a trade versus how much profit is expected. This calculation is made prior to entering the trade. Risk/reward ratios provide an unemotional way of evaluating a trade to find opportunities where the potential reward outweighs the known risk by a certain amount. For example, a trade which risks 1 point with a profit target of 3 points would have a risk/reward ratio of 1 to 3 (1 point of risk versus 3 points of gain).
What are the Myths of Risk-to-Reward Ratios?
Many trading systems advertise impressive risk/reward ratios associated with their trades. The problem is that risk/reward ratios are entirely theoretical, by nature. The reality is that a trader can only know the risk in advance (how much you're willing to lose), but the potential reward can be known only after the fact, no matter how compelling the trading setup. One may speculate as to the amount of reward he believes the market will provide on a given trade, but this can not be known until the trade is complete. Therefore, it is virtually impossible to determine the true Risk-to-Reward Ratio before entering a trade.

One useful alternative to the Risk-to-Reward Ratio method is for the trader to simply establish a firm risk tolerance which would represent the maximum amount of points he/she is willing to risk for all trades, regardless of their projected reward (price target). So, for example, whether a trade was forecasting a 5 or 10 point target, the risk would remain the same. Messenger Pro utilizes such a strategy because this approach manages what can actually be known in advance, which again is the amount of risk taken. Messenger Pro never intentionally risks more than 1 1/2 points on any trade, in spite of its projected price target.

Another common myth which shows up repeatedly in the advertising of trading systems is the deceptive promise that a trader can risk a very small amount of money to capture a very large gain, and do so repeatedly. An example would be the promise that a trader can risk 1 point and repeatedly profit 10 points. This claim is pure fantasy, with rare exception. The reality is that risk and reward are 2 sides to the same coin. If you seek to capture larger gains, then it is naturally necessary to risk larger amounts of money.

You'll find this principle of balanced risk versus reward is not isolated to trading the markets. It shows up virtually everywhere. For example, throwing a basketball into the hoop when you are two feet away has less risk of failure and is dramatically easier to achieve than shooting from the half court line, where the risk of failure is much higher but so is the points reward.

In summary, it is important to understand that both risk and reward run together. With rare exception, larger gains require larger risk. Traders should establish a personal risk tolerance that is reasonable for their account size and trading objectives (short-term day trading, medium-term and longer-term trading). Avoid getting baited into trades with supposed superior risk/reward ratios. By observing these general guidelines the likelihood of producing consistent, positive results increases significantly.

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