How do you determine proper risk and reward in trading? I don’t think anyone can ever provide a definitive answer to that question because its is akin to asking how many layers do you need to walk outside of my apartment in New York City in the winter.
Right now as the thermometer reads a balmy 8 degrees Fahrenheit as I type this at 3 in the morning, you need about four layers just to make it to the coffee shop across the street. But just last week you could have made the same journey in a T shirt without feeling a chill.
Trading, like the addled, globally warmed weather of my great metropolis is an imprecise and a highly volatile proposition. Therefore the question of risk and reward always changes with the circumstances of the moment. The traditional view on risk and reward is to set the ration to at least 2:1 – risking half the amount of pips as you are trying to make, so that if your profit target was 100 then your stop would be 50.
In theory this sounds like a terrific plan. You only need to be correct 4 out of 10 times to make money. However, I’ve never met a real life trader who actually put this principle into practice. I’ve received plenty of such advice on this matter from analysts, strategists, trading coaches and a whole host of others who have never wagered so much as their breakfast money on a trade, but I have never seen the 2:1 ratio employed by anyone who actually makes their living from the market.
The primary reason is that most people who never trade, do not realize that there is no such thing as reward in the market. There is only risk. Markets are not like factories that manufacture profits to your order. In fact, markets do everything possible to frustrate your goals.
Imagine a trade where you risk 100 points with a profit target of 200. Initially the trade goes your way and the floating p/l quickly rises until it reaches +199. Disciplined in your 2:1 strategy you wait for the profit target to hit so you can book another good trade.
But guess what? The market suddenly stalls and then reverses. You watch in horror as the positive trade quickly turns negative and then drops through your stop. What was you loss? On paper you lost 100 points, but in actuality you lost -299 points ( 100 points on your stop and -199 you did not book). Welcome to real life trading where the “theoretical” 2:1 risk reward is far more elusive than you think.
The fact of the matter is that profits cannot be forecast in the market. The only thing you can control is risk. That’s why we always trade with two units. That’s why we always take short first targets and that’s why we assiduously control risk by trailing our stops. It may not be glamorous, but its the only way we know how deal with risk and reward at BKT.