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Risk Reward ratio & Money-management strategy- PART 1

For a trader/investor, to make consistent profits in market, managing risk-reward ratio in his trades is the key to his final success. No matter with what strategy you comes in the market, if you are not following the strategy with a proper money-management plan,it will fail at the end for sure as no strategy can have a 100% success rate & the secret of making consistent profits is nothing but managing your risk or losses. As a price action trader,I got my plans ready in place regarding money-management in my each trade & here today I’ll explain the entire plan I follow in my every day’s trading. The major areas covered in my money-management plans are –managing risk:reward, position sizing & fixed Rs risk vs. percentage risk.

For all of us looking for a sustained consistent money making trading career, hopefully this article will give us a different direction to our mindset towards trading.

• Managing Risk Reward ratio in a trade :

In simple words, risk reward management in trading means – “how much you risk in a trade against the amount of money you make.”

Risk reward is the most important part of a trader’s money making process in the market. Most of the traders fails in managing this part even though they have a good strategy in place. Every trader wants to maximize profits & minimize losses & that is the key of being a successful trader. But in real world of trading, you’ll see people doing opposite to it. Traders loose more money when they are in loss & capture less when they make profits. The reason most of the traders are not able to take full advantage of the power of risk reward because they lack one thing & that is PATIENCE – they are not able to keep patience to execute a series of trades in order to realize the ultimate positive result of following risk reward. Below are some key components when I design my risk reward plan :

1)    My reward is always minimum 3 times higher than the risk taken in a trade

2)    I risk the same amount of money in each trade & never trade based on percentage(%) risk per trade

3)    I manage my position sizing(no of shares I buy/sell) based on amount I am risking in the trade.

4)    I do not measure my profit/loss in trading a/c after each trade but I measure total profit/loss after a long series of trades. Usually after 50 executed trades, I sit back & evaluate the trading results in monetary terms as i want to give some space to my trading strategy to work out.

5)    I do not monitor price movement after a trade entered & never edit my stoploss/target  orders.

We’ll discuss each of above topics step by step & I’ll show you how following a proper money-management plan will turn around your trading career towards success even following a simple trading strategy with a success accuracy of 50% or less.

1)    MY REWARD IS MINIMUM 3 TIMES OF RISK TAKEN IN A TRADE :

Before entering a trade we must have 3 things ready on our trading desk- entry level, stoploss level, target level. Lets understand the concept with a chart example :

In below chart, we can see a PIN bar buy signal formation on a flip support area (learn : FLIP level strategy)of 240 with an existing uptrend.Price rotated up from PIN bar buy signal & reached our target area of resistance level-260.Once price crossed this area of resistance(260), it continued its upward momentum with huge gains.

Now lets check, Once PIN bar buy signal is formed on key flip support, how to  enter this trade with a 3times reward vs 1time risk ( risk:reward = 1:3 ).

Once my trade setup is ready , First thing I’ll note on my trading dairy is : “stoploss” & “target”

So on this trade in below shared chart,

Stoploss = few points below PIN bar’s low = 235.90 here (lets assume 236 for easy calculation purpose)

Target    =  next level of resistance = 260 here

Once I get my target & stoploss, now I calculate my possible entry price based on 3times reward vs 1time risk.So here is the formula I use:

 For buy entry = ( target price – stoploss price ) /4 + stoploss price

For sell entry  = (stoploss price – target price ) /4 – stoploss price

So here on below chart, buy entry = (260-236)/4 + 236 = 242

 It means, if I get a buy entry opportunity at the rate of 242, then only I’ll be able to hit a risk reward ratio of 1:3 hence I’ll place a buy limit pending order in the trading system alongwith stoploss & target orders & let the order execute on it’s own.

 So this is how the order will look like below:

 Once my target area is hit, usually I prefer to see a bearish formation to exit my full qty from the trade, but as you can see price is strongly moving up & easily cleared the resistance level of 260 hence I’ll hold some of my shares to exit later once I see a price action bear signal or I notice some trend exhaustion at some point. Anyway, chart shows the trade has offered us a 6R gain if we would hold the trade longer even after hitting our target area of resistance.

Now, below is another chart example i traded few days back & shared the entry on blog . The trade was based on a PIN bar buy signal formation (learn : PIN BAR strategy)on a flip support area of 1000 with an existing uptrend.Price rotated up from PIN bar buy signal & reached our target area of resistance(learn : support-resistance strategy) level-1060 which is the equidistance channel’s top.

Now , lets have a look in below chart, how we entered the buy trade in nickel with a risk reward calculation of 1:3 using the same formula we discussed above.

In some cases , you will not be able to catch risk reward of 1:3 & i do not care at all if i miss a trade in case price does not come down & hit my buy limit entry order.For me, being discipline in trading rules are more important for consistent money making process in long run.Its OK to miss a trade if it does not fit in your money management plan but it’s not OK to break the trading rules you planned. Lets take an example below where i missed a buy entry & market shot up in my direction.

In lupin, The trade was based on a PIN bar buy signal formation (learn : PIN BAR strategy)on 20ema (learn : 20ema strategy)support area of 1140 with an existing uptrend.Price rotated up from PIN bar buy signal & reached our target area of resistance(learn : support-resistance strategy) level-1200.

Now lets have a look in below chart, where i placed my pending order to match risk reward ratio of 1:3. As you can see on chart, price did not come back after PIN formation to hit my buy entry order & shot up towards my target area. So i missed the trade even though my analysis worked out & you’ll have to accept it as this is part of this trading business.Do not chase the market, let the market come to you.

Now the next part is ” I risk same amount of money in each trade “

Risking same amount of money in each trade will help you to manage your risk reward ratio properly. If your risk per trade does not have same amount of money , the outcome of following risk reward ratio will not work out. Lets understand this topic with an example:

Lets say, we have a trading capital of Rs 1 lakh & we have a risk % in our mind is 40%(Rs 40,000) of the total capital in case we loose.

Now , we need to decide the most important thing where most of the traders make a mistake. I have seen many traders risking entire account in a single trade with a hope to make a lot of money in a single trade overnight but they never think about the other side of market behavior. I personally suggest traders to take care of their loosing trades first & if you do so,profits will follow you without managing them.

Coming back to the example, lets assume we decide to loose Rs 40,000/ in 20 trades which means if we loose 20 trades in a row,we end up loosing our total risk amount. Now as a price action trader, we never loose 20 trades in a row. As per probability, even i feel noone can be wrong 20 times in a row with whatsoever strategy he follows.Anyway, Once we decided 20 trades to be executed in our account, next step will be deciding the risk amount in each trade.To loose Rs 40,000/ in 20 trades,we’ll have to risk Rs 2000/ in each trade. Now lets assume we started trading & we are not super expert trader & hence our performance percentage is not more than 50% success, means – out of 20 trades we loose money in 10 trades & we’ve hit our target in 10 trades with a risk reward of 1:3 in each trade.

So the math will be,

we lost 10 trades with a risk amount per trade rs 2000 = Rs 2000 * 10 trades = Rs 20,000/

we win 10 trades with a reward/profit  amount per trade rs 6000 = Rs 6000 * 10 trades = Rs 60,000/

Total net profit = Rs 40,000/ ( with a success ratio of 50% )

So even with a success ratio of 50% , we can make money in the market with any simple trading strategy but followed with powerful money management system.

Here we managed to make 40% profits on our trading capital of Rs 1,00,000/ even after loosing 50% trades.Most traders loose patience when they hit a series of loosing trades for 4 to 5 times in a row & stop trading further hence they stop the process of right execution of their trading strategy & money management plan over a series of trades. With a risk reward ratio of 1:3 , you need to be correct for minimum 26% of trades you do, to make the score in breakeven(no profit no loss) which means you do not loose money even after lo0sing 74% of your failed trades. Now as a trader, do you really think you’ll loose 74% of your trades?????????? Surely not as a price action trader – as a price action trader & the strategy i use,you will have a success ratio of min 50-60% in your executed trades being an average type of trader.

So treat your each trade with equal importance & never get excited & bet more money in your next trade after winning a few trades in a row which may blow your entire account.Remember we never know what will be the final outcome of our next trade but using a trading edge like price action strategy, we improves the chances of the trade to play in our favor.Hence we say, . So when you loose money in a trade,let it be lost being played in a trading plan but not as an accident.

There are a lot more to discuss on this topic & i’ll be covering all the topics in my next article with clear explanations. For today, we’ll stop here & let me inform you the important upcoming topics in my next article regarding money management rules i follow :

* why following % risk per trade is a disaster for traders

* Position sizing process once entry area & risk amount is defined

* Why i do not monitor the trading screen once my trade orders are placed

* Example of trading results after a series of trades execution & why i focus on “Do not count your trading results after every single trade & count your results after a series or a set of trades”

……………………………………………………   & lot more.

December 12, 2014

4 responses on "Risk Reward ratio & Money-management strategy- PART 1"

  1. Thanx Rajib. The explanation is really helpful. When will you release the other points ?

  2. hello sir please send me intraday strategy 1:3 ratio money managment

  3. Excellent

  4. if i can not get 3:1 Risk reward ratio what should i do ? should i book less profit or wait for loss to happen ? can i calculate risk /reward ration on all my trade or each trade wise .

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