Supply and demand trading course

Money Management
The Risk to Reward Ratio (Detailed
Text Lesson)

Supply and demand

The Risk to Reward Ratio

(Detailed Text Lesson)
LESSON 54 MODULE 9

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.

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