Risk Reward of 1:2.5
Take as the basis of a risk management strategy that for 1 unit of risk, the trader aims for 2.5 units of reward.
There are several concerns to take into account over and above the 1:2.5 concept.
Firstly, the brokerage spread. Is this included in the ‘1’ risk – let’s assume YES it is.
Thus, our risk in the market is actually 1 unit minus the broker spread.
The 1 unit can represent any number of points.
For example, the matrix below shows 10 pips GBPUSD are risked in a long (buy) trade (including a spread of 1.4 pips).
ENTRY. 1.34560 (ask)
STOP LOSS. 1.34460 (bid)
This risk is therefore 10 pips of money, but only 8.4 pips of actual change in the exchange rate bid price, assuming the spread remains the same.
Note, in extremely volatile and/or illiquid markets, it is possible for the spread itself to widen to that 10 pips, which in a bad-case scenario, could cause a stop out withouth the price having even moved.
However, let’s assume for these purposes that the spread fluctuates, but is fairly stable, around 1.4-1.8 pips, averaging at 1.6 pips for the duration of the trade.
Why do I labour such a point?
Simply, because most traders do not think about it, and as a result, over the course of a great many trades, are not factoring in the amount of commissions (spread) paid out – the transaction cost of the trade.
Furthermore, slippage should be considered. The slippage on the trade should be factored in as well. Let us therefore immediately allow for 0.9 pips of slippage when getting out the trade.
Therefore, we move our stop as follows.
|STOP LOSS SELL STOP ORDER (BID).||1.34469 (BID).|
Achieving the desired reward
To achieve the 2.5 reward mentioned, the target needs to be set at SELL LIMIT 25 pips ahead of the price.
Currently, 9.1 pips are at risk if we are filled by the broker at the desired levels, which ought to be the maximum at risk, under liquid market conditions.
The 0.9 pips of slippage would mean 10 pips at risk (including spread and an assumed slippage of 0.9 pips).
Let us assume that we will experience slippage and therefore go for 2.5 x 10 = 25 pips of reward on the trade.
New risk reward matrix
Therefore, we need to take profit (sell limit / exit / close) the trade at 1.6 + 25 + 0.9 pips = 27.5 points from the entry price.
STOP LOSS SELL STOP ORDER. 1.34469
TAKE PROFIT SELL LIMIT ORDER. 1.34835.
Example with money
Summary and development
Let’s assume now $10 per pip.
MAX LOSS is $100 (assuming maximum slippage is against us and 0.9 pips).
MAX PROFIT TARGET is $250 (assuming maximum slippage againt us and 0.9 pips).
NB. It is possible, with a good broker, that slippage can go FOR the trader – say a specified stop order is hit, and the price slips back down, creating less of a loss than was expectd, similarly a better profit can be gained from positive slippage. But we will always assume a bad-case scenario, with a view to better capital protection and higher profits over the long run.
With this trade set up and filled at the entry price, we can literally walk away and let the trade roll.
However, the conditions of and confidence in the trade might change.
Here are two ways the trade can be managed, which alter the risk reward, but also allow some profit taking, without ever risking more than the worst-case final profit target (once the trade management is instigated).
Assume the trade reaches 1.75 x the risk in the profit direction.
Trade management decision
A new decision is made along the following four lines:
(i) Probability of reaching 2.5 is stilled deemed EXCELLENT. Keep the original parameters entirely (10 pips risked, 25 pips aimed for as target). 1:2.5 risk to reward. No change.
(ii) Probability of reaching 2.5 is still deemed EXCELLENT, with strong momentum and one or more new swings in place above the entry. Bring the stop to break even + 0.9 pips (0 pips risked, 25 pips aimed for as target). Trade is now 0:2.5 risk to reward, we are trading with the market’s money and support below that is above our entry.
(iii) Probability of reaching 2.5 is still deemed GOOD, partial close.
(iv) Probability of reaching 2.5 is deemed OK, partial close.
Partial close scenarios
We will only consider scenario (iii) and (iv) in this post.
The following comes directly from the trading plan I use to manage my fund.
22.214.171.124. IF a 1.75 target is set and reached, but there is some probability of reaching 2.5 or more, then 0.75 can be closed at 1.75 and stop brought to BE+2, which would mean a 1:1.3125 risk reward +2pips if stopped out, or 1.9375 if goes on to reach 2.5 target.
126.96.36.199. IF a 1.75 target is set and reached, and there is good probability of reaching 2.5 or more, then 0.6 can be closed at 1.75 and stop brought to BE+2 which would be 1.05 risk reward + 2 pips if stopped out on remaining, or 2.05 if 2.5 reached.
In other words, 3/4 of the trade can be closed out at 1.75 reward (based on 1 unit of risk). The stop can then be brought up to say BE+2 (or BE+0.9 we have been working with as a less conservative estimate of bad-case slippage).
This leaves 1/4 of the original position in the market, with a bad-case loss of between 0-2 pips on the remainder of the position.
If this remaining quarter is stopped out, the final risk to reward of the trade becomes 1:1.3125.
If the remaining 1/4 position reaches the original target of 2.5, then the final risk to reward ratio of the trade will be 1:1.9375.
In other words, 3/5 of the trade is closed out at 1.75 reward, and the stop brought up to break even + 2 pips (to cover slippage and give an incremental increase to mitigate unexpected slippages on other trades, for example).
If this new stop loss gets hit, taking out 2/5 of the trade with effectively 0 pips profit, our risk reward ratio remains 1:1.05 for the entire trade.
However, if the original take profit is hit with the remaining 2/5 which is still trading in the market, then the risk reward for the trade is 1:2.05.
Thus, if 2.5 risk to reward is considered too high, the level can still be used as the final target, but a partial close will allow locking in of profits to create a minumum 1:1.05 risk to reward, and maximum 2.05 risk to reward, if closing out 3/5 of the trade at 1.75, or a minimum risk to reward of 1:1.3125 and maximum or 1:1.9375 if closing out 3/4 of the trade at 1.75 reward vs the risk taken of (-)1.