Your reward targets should always be greater than what you are risking (ideally more than twice the risk). However, R:R is an arbitrary gauge of good money management if you do not consider % risk and the target win ratio.
For instance, a 4:1 risk-to-reward ratio with your trades can, surprisingly, still blow your account. Having a low target hit ratio or excessive risk in a single trade could result in your financial ruin. Consult the next sections for statistical tables indicating percent risk in a trade.
As shown on the chart above, the distance between the entry order and the stop loss is what you are risking, and the distance between the entry order and target (take profit) is your reward.
In this example, the amount of risk is half of the reward—the right track in money management. In the following section we will discuss the next step: determining the size of your positions.
Variable Position Sizing
As part of your money and risk management plan, you should learn to trade in small steps or lot sizes. If you are not profitable with smaller lots, why would you be successful with larger lot sizes?
Therefore, it is wise to start with a 0.5% risk per trade and gradually move up to 2% once you feel comfortable and have had enough success. Your number one goal when you start trading is not to make money, but to protect your capital at all costs.
Here is an example of % risk.
Example No. 1 – 1% at Risk
- Account Size: $1,000
- Maximum Risk: 1% of $1,000, ie, $10
- Stop Loss Risk: Less or Equal to $10 (<=$10)
In connection with this lesson, you have been provided with a “live” variable position size Excel spreadsheet that is an excellent resource to determine the correct position sizing with the associate %risk and currency pair.
There is a live feed to this Excel spreadsheet to input the correct currency exchange rate. (If you are not connected to the internet it will not function properly.)
Although 1% account equity is meant for a general guideline when you start learning, it should be practised until you have a comfortable level of understanding of the markets.
If you use a 2% on a $2,000 account, you do not want to risk more than $40 per trade; as such, you would be putting your stop loss orders at a level of $40 or less.
Some argue that rather than having a percent risk, there should be a fixed-dollar amount. In theory this does make sense, but it does not hold up in reality and, in my opinion, it will most likely kill your account slowly.
I prefer using a percent risk, as the amount at risk will decrease with my drawdowns and increase when I am on a winning streak.
The chart below will depict a hypothetical scenario where trader A assumes a %risk per trade and Trader B assumes a fixed dollar amount.
The wining table on the left shows the difference between an account that uses money management (MM) and one who does not, while risking 2% per trade.
The losing table on the right shows the difference between an account that uses money management (MM) and one who does not, while risking 2% risk per trade.
MM allows your capital to grow exponentially while at the same time helping you avoid risk of failure, assuming a fixed-dollar risk value is not executing proper money management.