Debunking the Risk: Reward Myth
04/28/2014 6:00 am EST
Basing a trade decision on risk:reward ratios makes perfect sense on the surface, but dig deeper and you'll realize that you're basing a decision on incomplete information, according to Erich Senft of the Indicator Warehouse.
I got an interesting question from a member the other day. It's a question I get a lot. This member asked "how can you make money without a positive risk/reward ratio?"
If you've followed my trades for any time at all you'll notice that I'm not a big fan of risk/reward ratios. Very often my risk/reward ratios are very lopsided, and by that I mean I'm risking more than I expect to make in the trade, so naturally people are confused and they wonder how can this be?
After all, everyone knows you need to have at least 2:1, and ideally 3:1 reward to risk, right? That's what all the gurus say. But is it true?
Yes, on paper risk/reward ratios make perfect sense: your reward should be more than your risk, but the problem with risk/reward ratios is that no one knows the reward side of the equation! We all have our best guesses of where the market will go, but the fact of the matter is no one can consistently predict where the market will go next, so why would you base a trade/no-trade decision on something you don't know?
And if you're like me, you've had many good risk/reward trades come up well short of their reward targets, and other trades with poor risk/reward ratios that went well past where they were supposed to go. No, risk/reward ratios are one of those trading lies that sound good but don't work in real life. Risk/reward ratios do not help you make money.
So rather than focusing on risk/reward I focus on probability: what is the probability that the trade will work out? Risk/reward ratios have nothing to do with the probability of a profitable trade, but a trade's probability is much more important that its reward relative to the risk.
Besides, unlike the reward, a trade's probability is something you can figure out objectively. And once you know the probability of a trade working out, trading becomes a matter of risk management. Risk, unlike reward, is the only part of the trading equation you have any control over. So if you can afford the risk, take the trade. It's really that simple.
Try it and see for yourself. I think you'll find that probabilities combined with risk control are a very powerful combination for making money. Much better than risk/reward ratios.
By Erich Senft of Indicator Warehouse