Make Sure Risk/Reward Is on Your Side

08/01/2011 11:00 am EST

Focus: STRATEGIES

Derek Frey

Chief Market Strategist, Carnac Investment Advisors, LLC

Taking trades with favorable risk/reward ratios makes for a higher probability of being successful over time, says Derek Frey, who also reveals the minimum ratio he looks for in each trade.

Traders are always being told that a good risk/reward ratio is important in their trading, but what does that really mean, and what is a good ratio?

Our guest today is Derek Frey to talk about that. Derek, first of all, what is risk/reward ratio?

Risk/reward ratio is simply having more profit potential than risk for each trade that you’re taking.

A classic example is the coin flip. We all know that flipping a coin is 50/50, so if we’re flipping coins and when you lose, you lose 99 cents, and when you win, you make $1.01, if anyone wants to play that game with me, I’ll play it forever because I’m guaranteed to make money over time. 

I don’t know which flip of the coin is going to make me money, but I know because I’m making a penny more than I’m losing (when I’m losing), I’m ultimately going to make money over time. So, that’s really all it is.

It’s just consistently putting yourself in a situation where you have—I hate to use the word “realistic”—but where you have a genuine, quantifiable way of having more reward than risk.

It’s not just hope that you’re going to make more money. It’s not just “I would like to make 500 points on this trade,” it’s actually having some sort of a real reasoning behind why. I have a 1.5-to-1, or 2-to-1, or 3-to-1, or whatever it is, that’s really important.

What’s a good ratio? I know some traders, they will take no trade less than a 5-to-1, but it sounds like you want 1.5-to-1.

Yeah, 1.5-to-1 is my minimum threshold. I would prefer 2-to-1 or 3-to-1, but the risk/reward ratios also have a point of diminishing returns. I can create trades that have 1000-to-1 risk/reward ratio, but their probability of success is probably 1 in 1000.

You don’t want to go too far out on the scale because then you’re basically just buying lottery tickets. So, in my world at least, there’s a sweet spot basically between 1.5-to-1 and 4-to-1. I try not to go too far beyond that.

On a chart, is it a matter of seeing where the next support or resistance is to find that ratio, or what do you use?

Well, for me it has to do with the harmonic patterns, so we’re always looking to get back to the B point of the patterns, and the risk is always clearly defined for us through the PRZ on those entry boxes, so it’s actually pretty easy, and fairly automatic, just to measure those two things and see if there’s a favorable risk/reward, and then you’re in.

See video: Harmonics Give a Mathematical Edge

So, a lot of people use that risk side as just a percentage of their account that they don’t want to lose any more of. Is that a way to do as well?

Yeah, absolutely. In the course that I teach, 1% or 2% of your account—at most—for anyone trading, and even that can be high. 

You never want one trade to affect your bottom line to such a degree, win or loss, that it’s going to have a major impact to you. It should be the sum of thousands of trades, not one or two, that causes a huge swing.

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