Risk Reward Myth

Jan 8, 2011
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#16
I actually think risk:reward is a load of b0ll0cks myself, as it implies that the market actually cares about what you're doing. Furthermore, it implies that the only strategies which can make money are those with a ratio of 2:1 or 3:1.

You set the risk, the market gives you the reward.

However I think there's a little grain of truth behind the idea of 2 or 3:1, as it clearly implies small losing trades and big winning trades.

One of the main cognitive biases leading to losing money is cutting winners too soon and running losses for far too long. If you were to stick with 2:1, that's not going to happen.

Having said all that, I trade a trend model where I don't have any profit targets.. I've been unable to find a robust mechanical system which uses profit targets, and indeed when I did trade this way, I frequently came across the dilemma whereby (e.g.) the profit target was 100 pips, and the market would get to +97 pips before reversing. Profit targeting doesn't really tell you what to do in these circumstances.
Profit target with a trailing stop ;)
 

alexander

Active member
Mar 19, 2005
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#17
Expected_gain = Expected_win x Probabilty_of_win - Expected_loss x Probability_of_loss

We try to choose the entry, target and stop so that the expected gain is positive and that the risk:reward is sufficient:

RR = Expected_win / Expected_loss.
I agree more or less but I have a few comments to make. First, the formula you wrote holds only at the limit of large numbers, meaning that you need hundreds of trades for it to produce a stationary value for the expected gain.

Second, Expected win = expected loss = expected value of a trade. RR is usually defined as profit objective/stop loss.

Regardless all the semantics, see how this guy proves that Expected_gain > 0 is equivalent to saying that net profit is zero. The two statements are equivalent:

http://www.priceactionlab.com/Blog/2010/12/what-is-a-trading-edge-part-ii/

Meaning that if you make a net profit, expected_gain must be positive. Simplicity is a virtue.
 

jel31

Active member
Dec 4, 2007
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#19
I sit on the 1:1, high win rate side of the fence.

With multiple setup's occuring each day my objective is to finnish each day with a profit or an easily recoverable loss.

There is also the benefit of not worrying about missing rocket trades that would have made up for the last 2-3 losers.

This type of setup works better in choppy conditions as well inmy opinion.
Agreed!

I like setting orders for 1:1 then trailing stop. This means that average loss will always be less than average win and with a minimum 50% win rate, long-term the figures add up (in theory!)

Very interesting discussion! :)
 

hoodoo man

Active member
May 2, 2011
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#20
Indeed, a beginner's mistake is to assume there is a 50/50 chance of success and is predicated on the trade situation being simply random.
They also assume that there is a 50/50 chance of a 1:2 or 1:3 etc risk/reward being hit.
That is absurd, but even seasoned traders have it rooted in their minds.
Richard

Very good point. Where does this canard come from? I see some of the beginners stickies and "first steps" articles contain misleading things like this...
 

kimo'sabby

Well-known member
Apr 3, 2010
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#21
As a chart trader when i think of Risk:Reward i think of inherent volatility and realistic trade parameters to fit. I never really think about mathematical probabilities as such, maybe i should, seems to be all the rage.
 

theroguetrader

Active member
Jan 6, 2008
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#22
Indeed, a beginner's mistake is to assume there is a 50/50 chance of success and is predicated on the trade situation being simply random.
They also assume that there is a 50/50 chance of a 1:2 or 1:3 etc risk/reward being hit.
That is absurd, but even seasoned traders have it rooted in their minds.
Richard



statistically speaking, trading the market with a 1:1 risk reward ratio and no strategy or trading edge has a 50% chance of success (minus fees) over a long series of trades. ie - most traders should approximately breakeven over the long run because trading with a (truly) random entry and a 1:1 risk reward is the same as a random coin toss -

the MAIN THING that definitely prevents MOST PEOPLE from making money in the market is OVER TRADING .. !! traders who just jump in and out of the market on " emotion and greed ", will not only suffer many more losing trades, but they will also rack up a lot more fees via spreads and (or) commissions over the course of a year than traders who stick to the higher time frames and understand the value of self discipline and having PATIENCE. Trading lower time frames causes many traders to over-trade because they end up thinking they see many more trading signals worth trading, when in reality there is just a lot more “junk” signals and “noise” on lower time frames -

Human beings have a tendency to see patterns that don’t really mean anything. This is especially true in trading; if you stare at a chart long enough you can make up all kinds of things that “should” happen based on what you “ see ” !! - you have to develop PATIENCE so that you aren’t guilty of “manifesting” irrelevant patters in the market - which traders do ALL THE TIME !!
 

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theroguetrader

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Jan 6, 2008
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#23
As a chart trader when i think of Risk:Reward i think of inherent volatility and realistic trade parameters to fit. I never really think about mathematical probabilities as such, maybe i should, seems to be all the rage.

RISK/REWARD IS " THE " most important thing in trading !!

if you take your profit at R1 - you might as well toss a coin -
if you take your profit ar R2/R3 - you could be(WRONG) on half your trades and still be in PROFIT - OVER TIME !!
 

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theroguetrader

Active member
Jan 6, 2008
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#25
Or you could take 3 parts profit at R1, 1 part at R2 and the last 1 part at R3.

or open 3 lots, enter at 50% of the pin (if it retraces there), take 2 lots off at the break of the low of the pin (and vice versa) and run the other lot -
 

kimo'sabby

Well-known member
Apr 3, 2010
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#26
RISK/REWARD IS " THE " most important thing in trading !!

if you take your profit at R1 - you might as well toss a coin -
if you take your profit ar R2/R3 - you could be(WRONG) on half your trades and still be in PROFIT - OVER TIME !!

Mmmm, it's arguable. Gonna relax now, i'll get back t'ya tommoz.
 
Jul 10, 2003
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#28
Well done to hoodoo for responding to a 6 month old thread, but yes, the whole R:R is bogus.

The likelihood that anyone can accurately calculate their likely reward is patently absurd. Your risk is the only thing over which you have any control.

You get to choose when and if and where to enter. And you get to chose where and when you exit. That’s it.

You make a 1:1 well done. You make a 1:3 really well done. You make a 1:0.01 – it’s not a loss. You make a 1:-0.01. Well done. It’s not a major loss.
 
Jan 13, 2011
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#30
another reason why R:R is bogus is because getting out of a position just because you are losing money is not always good. It by defenition puts you in the "weak hand" group

I mean if the reasons for your long trade are still good, and its gone against you, buy more!