Rethinking How to Use Risk/Reward – PART 2

Risk/Reward Moves Inversely to Favorable Price Action

Here is an example. Let’s say you buy GBPUSD at 1.6600; you place a take profit order at 1.6700 and a stop loss order at 1.6500. Your risk is 100 points and your possible profit is 100 points. The risk/reward is 100:100, which is a 1:1 risk reward ratio.

Now let’s say the trade moves in your favor by 80 points so GBPUSD is now at 1.6680. Let’s recalculate the risk reward; the risk is 180 (1.6680-1.6500) and the reward is 20 (1.6700 -1.6680). The risk/reward is 180:20, which is a 9:1 risk/reward ratio. You are now risking 9 to make 1.

So why is this Important?
Because it challenges the concept of letting your profits run. If I were to ask 10 people if they wanted to let their profits run(try for that last 20 points) or close the trade and take the 80 points profit; 9 out of 10, if not 10 out of 10, would say take the 80 points. The point is this; letting your profits run is not worth the risk at some point.

How Does Risk/Reward Move in Relation to Unfavorable Price Action?
Here is an example. Let’s say you buy GBPUSD at 1.6600; you place a take profit order at 1.6700 and a stop loss order at 1.6500. Your risk is 100 points and your possible profit is 100 points. The risk/reward is 100:100, which is a 1:1 risk reward ratio.

Now let’s say the trade moves against you by 80 points so GBPUSD is now at 1.6520. Let’s recalculate the risk reward; the risk is 20 (1.6520-1.6500) and the reward is 180 (1.6700 -1.6520). The risk reward is 20:180, which is a 1:9 risk/reward ratio. You are now risking 1 to make 9.

So why is this Important?
Because it challenges the concept of cutting your losses. If I were to ask 10 people if they wanted to cut their losses (not risk that last 20 points) or keep the trade open and possibly make back the 80 point loss plus an additional 100 points profit (180 point turnaround); 9 out of 10, if not 10 out of 10, would say keep the trade open and risk the last 20 points. The point is this; cutting your losses to save a small part of your risk (in this case saving the last 20 points) is not worth the elimination of any chance to recover and profit from the trade at some point.

So what’s the solution?
A trailing stop loss that keeps the risk reward close to what it was when the trade was entered is one possibility. Another possibility is multiple lots.
Multiple Lots – Lock in Profits and Reduce Risk
This trade management strategy starts with a 1:1 risk/reward ratio. From there a relatively small favorable price action reduces the risk by 83% and dramatically improves the risk/reward ratio. Another relatively small favorable price action eliminates all risk and locks in a guaranteed profit.
Here is an example:
1. Buy 3 mini lots (30,000) of GBPUSD at 1.6600
a. Stop loss is $120
- Sell 3 mini lots if the pair goes down 40 points (1.6560); risk is 3X40=$120
b. Take profit is $120
- Sell 1 lot if pair goes up 20 points (1.6620); profit is 1X20=$20
- Sell 1 lot if pair goes up 40 points (1.6640); profit is 1X40=$40
- Sell 1 lot if pair goes up 60 points (1.6660); profit is 1X60=$60
- Risk/reward is $120:$120, or 1:1 risk reward
 2. The first action is either:
   a. GBPUSD goes down 40 points and the stop loss is triggered
- Sell 3 lots 40X3=$120 loss
- Bottom line you lose $120
   b. GBPUSD goes up 20 points and the first take profit is triggered and the stop loss is raised by 20 points
- Sell 1 lot 20X1=$20 profit
- Remaining position is long 2 lots
- Move stop loss up by 20 points (to 1.6580 from 1.6560) on the two remaining lots 
3. Let’s assume the GBPUSD pair increased 20 points to 1.6620, and that triggered first action b; now let’s recalculate risk/reward:

- Long 2 lots we bought initially at 1.6600
i) The stop loss is now 1.6580
 ii) Maximum risk on the two remaining lots is 20X2=$40
 iii) The other lot was closed at a profit of $20 (1X20)

Therefore after first action b; the maximum loss is $40 on the two remaining lots, which would be partially offset by the $20 profit on the lot already closed. Which means a loss of $20 is now the worst case (the risk)

The potential reward remains the same – $120:
- Sold 1 lot after 20 points (1.6620); profit is 1X20=$20
- Sell 1 lot if pair goes up 40 points (1.6640); profit is 1X40=$40
- Sell 1 lot if pair goes up 60 points (1.6660); profit is 1X60=$60

The risk/reward is $20:$120 or 1:6 risk/reward ratio. The risk was reduced by 83%, from $120 to $20. You’re now risking $20 to make $120, you’re risking 1 to make 6.
4. The second action is either
a. GBPUSD goes down 40 points to 1.6580 and the stop loss is triggered
- Sell 2 lots 20X2=$40 loss
- Partially offset by the $20 profit on the first lot
- Bottom line you lose $20
b. GBPUSD goes up 20 points to 1.6640  and the second take profit is triggered and the stop loss is raised by 20 points
- Sell 1 lot 40X1=$40 profit
- Sold 1 lot earlier 20X1 =$20 profit
- Remaining position is long 1 lot
- Move stop loss up by 20 points (to 1.6600 from 1.6580) on the one remaining lot
5. Let’s assume the GBPUSD pair increased 20 points to 1.6640 and that triggered second action b; now let’s recalculate risk/reward:

- Long 1 lot we bought initially at 1.6600
i) The stop loss is now 1.6600
ii) Maximum risk on the one remaining lot is 0X1=$0
iii) The first lot was closed at a profit of $20 (1X20)
iv) The second lot was closed at a profit of $40 (1X40)

Therefore after second action b; the worst case (the risk) is a breakeven on the third lot and a $60 profit on the first two lots

The potential reward remains the same – $120:
- Sold 1 lot after 20 points (1.6620); profit is 1X20=$20
- Sold 1 lot after 40 points (1.6640); profit is 1X40=$40
- Sell 1 lot if pair goes up 60 points (1.6660); profit is 1X60=$60

The risk/reward is now off the charts so to speak. Worst case make $60 (if stopped out of 3^rd lot at 1.6600, which is breakeven). Best case make $120 (if 1.6660 take profit is reached on the 3^rd lot).

Summary Diagram

When it’s best to use Multiple Lots
Works best with momentum type trades. That is because the price just needs to keep doing what it has been doing most recently to reach that first action and reduce the risk by 83% and improve the risk/reward ratio from 1:1 to 1:6.
Another thing I like about multiple lots is the fact a positive action occurs after 20 points and a negative action happens after 40 points. All other things being equal, it’s twice as likely to get a positive action; because price only needs to cover half the distance (20 versus 40).
There is no requirement that you use the 20, 40, 60; it’s just what we used here as an example. What is key is to use the same proportions (e.g. 15, 30, 45; or 25, 50, 75).