THE RISK TO REWARD RATIO (DETAILED

TEXT LESSON)
Most beginner traders think that having a powerful trading system is all that they need to become profitable, they
spend years looking for that Holy Grail that will make their dreams come true. So, if you are one of them, I want to
tell you that the win rate of a trading system has nothing to do with your success as a trader. You can lose money
with a win rate of 90%or even 99% if you have a poor money management strategy. On the other hand, you can
become consistently profitable with a win rate of 30%, if you have a good money management strategy.

The good news is that when using banks and financial institution strategies in combination with a strict and wining
money management strategy, you will have one of the most powerful trading systems, and you will never struggle to
make money trading any financial market.
One of the most important components of money management is the risk to reward ratio, we have talked about it in
previous lessons as one of the most important conditions to validate a good supply or a demand zone, but we didn’t
talk about it in details. In this lesson we will talk about risk and reward in details, and I will teach you how to calculate
it, and how to identify supply and demand zones with attractive risk to reward ratios. See the illustration below :

As you can see in the EUR USD 4H chart above, we have identified a supply zone, when the market retested the
zone, we noticed the formation of a pin bar candlestick pattern, in fact it is similar to the Doji candle, but what
matters most is not the name of the candle but the psychology behind its formation. As you can see the market was
rejected strongly from the zone. So, to enter this trade, we need to place an entry at the close of the Doji or pin bar
candle, and the stop loss above the zone and the tail of the candle.

The distance between the entry point and the stop loss point is the risk that we will take, and as you can see by
calculating the pips between our entry and our stop loss, we found 23 pips. So, we will risk 23 pips in this trade.

How to calculate the reward?

The reward is the amount of money that you are going to earn if the trade goes in your favor, to calculate the reward
ratio, you need to identify the distance between the entry and the profit target and calculate the pips between them.
Look at the chart below:
As you can see above, this is the same EUR USD 4H chart. By identifying the distance between the entry and the
profit target we get the reward. So, by calculating the pips between our entry and our profit target we found 107 pips
Reward. So, this trade provides us with 1:4.5 risk to reward ratio.
Let me now give you another example of a demand zone to help you understand more about risk to reward ratios:

As you can see in the USD CHF H1 chart, we have a good demand zone, when the market pulled back to retest the
zone, prices formed a nice pin bar candlestick pattern. This is an obvious confirmation to enter the market.

Your entry is at the close of the pin bar pattern and your stop loss should be placed below the demand zone. By
calculating the pips between the entry point and the stop loss point we get the risk ratio. In this trade we have 213
Risk Ratio.

As I always say, the profit target is the next level, and here in this example we had a demand zone so the next profit
target should be the next resistance or supply zone.
As you can see by identifying the profit target, we can easily calculate our reward ratio, we start from the entry point
till the profit target point to get the amount of pips that represent our reward ratio. Here in this example we have 623
pips Reward. So, we can say that this trade provides us with 1:2.5 risk to reward ratio.

Position sizing and risk to reward ratio

It is absolutely paramount to your consistent profitability in the forex market that you understand the importance of
the risk to reward ratio and how it relates to position sizing.
Before entering any trade, you need to know the exact dollar amount that you want to risk and the exact reward you
think you can make on the trade. You will see why this is important in a minute.

Once you have determined the dollar amount, then you adjust your position size to meet this amount. If you are
trading micro lots and want to risk 50 dollars on a trade with a 100 pip stop loss, then your position will be 5
(remember 5 micro lots would be the half of 1 mini lots).5X100= 50 dollars.

So, you would have a position size of 5 mini lots (5 micro lots) risking 50 dollars with a per pip value of 50 Cent.

The risk to reward ratio concept is very important to understand, if you risk 100 dollars on a trade and your target is
set at 200 dollars, then you are doubling your reward if you win, this is a risk to reward ratio of 1:2. It is important to
realize here that with a risk to reward of 1:2 you can lose on over 50% of your trades and still make money over
time. In fact, you could lose 65% of your trades with a risk to reward of 1:2 and still make money. Over a series of 10
trades if you win only 35% of them with a risk to reward ratio of 1:2 you would profit 50 dollars if you risked 100
dollars per trade.

Here is the power of the risk to reward ratio when it comes into play. Many traders erroneously believe that they
must win a very high percentage of their trades to make money in the market. The fact is that winning percentage is
nearly irrelevant in whether or not you make money over the long term. What is important is if you are taking
advantage of the risk to reward ratio. For example, if you maintain returns of 3 times the amount you risk. Your risk
to reward ratio is 1:3. This effectively means you can lose 7 out of 10 trades and still make money. At 100 dollars
risk you would lose 700 dollars on 10 trades. But you would make 900 dollars off your 3 wining trades because your
risk to reward ratio is 1:3, thus you profit 200 dollars even though you lost 70% of the time. You should be starting to
see how it work now, why having a high winning percentage is not relevant. And why it is crucial that you maintain a
risk to reward of 1:2 or higher for every trade you take.

Risk is measured in dollars not pips

Position sizing allows you to adjust the number of lots you trade to meet the amount of money you want to risk per
trade, this allows you to use wider stops but still maintain your desired dollar risk. Many forex traders mistakenly
believe that a wider stop loss will mean a bigger risk. If your desired risk amount is 100 dollars but you want to place
your stop loss at a level that is 200 pips from your entry. Then you simply adjust your position size down to meet the
dollar amount.

For example, let’s say you are trading mini lots GBP USD, a 100-dollar risk with a 200 pip would need a position
size of 5 (or 5 micro lots). You would be trading the hold of 1 mini lot which would be 50 Cent per pip,50X200 =100
dollars. So just because you increase your stop loss distance does not mean you need to increase your risk. Many
people will adjust their stop loss but not adjust their position size, this is a major error and it is the main cause of
blown out trading accounts.

If you start out risking 100 dollars, with a 100 pip stop but then decide to move your stop up another 100 pips, you
have just increased your risk to 200 dollars (1 dollar per pipx200 pips =200 dollars). This is a cardinal sin in trading
and one you can’t afford to commit. You need to define your risk in dollars before entering the trade and then adjust
your position size accordingly to meet the desired stop loss distance so as to maintain the desired dollar amount
risked.
Similarly, many traders think that a smaller stop loss means a smaller dollar risk. This is not always the case
however; position sizing will explain this. If Joe trader has a stop loss of 50 pips but is trading 5 dollars per pip (5
mini lots) then his risk is 250 dollars on the trade. If Susie Piper has a stop loss of 100 pips but is trading 2 dollars
per pip (2 mini lots) then her risk is 200 dollars on the trade. As we can see a smaller stop loss doesn’t necessarily
mean a smaller risk, position sizing determines your dollar risk on the trade, not pips. So, from these examples, the
take home lesson is that risk should always be measured in dollar amount risked, not pips risked because the size
of your position is what determines your risk, not the size of your pips.