This article will deal with ration and how they can be misleading. This is just advice coming from professional prop traders in the US. You can take whatever you think is good for you and your trading system. Just know that a lot of Forex traders are using common risk/reward ratios of 2:1 or 3:1. We will try to explain here why using ratios is not really good for you.
As you already know the Forex market is really dynamic and things can change each second on a daily basis. In order to succeed and make a profit trading currencies besides some basic, or more advanced knowledge, depending on your level, and experience, you will need to have one more thing, and that is a really good money management skill.
We will now go back to basics and explain in short what these common 2:1, 3:1 risk ratios mean. Basically, a 2:1 ratio means that you can gain 120 pips, or you can lose 60 pips. A similar thing applies to a 3:1 ratio where you can make 180 pips before you lose 60.
The truth is you can make a profit using ratios mentioned above, but you are not able to see some things that other traders can, and that makes all the difference.
You can ask yourself, “Okay, I am making a profit, what’s wrong with that. It’s something right?”
The most noticeable mistake that a lot of Forex traders, that are using these risk ratios, make is in their approach. The first thing they are looking for is finding out where their Take Profit or TP is going to be. To be able to do that, they are trying to find out if there are a visible support and resistance line or maybe pivot point…
If you look at the chart, for example, EUR/USD daily chart. What happens usually, and you can probably notice it too, is that price can go up, and it stabilizes for some time. Soon, a support line becomes visible. Day after day, month after month there are price fluctuations. The interesting thing is that the price does not fall bellow, above mentioned, support line, or it does just for a short amount of time before it bounces back. In this particular situation, a lot of traders wanted to go long and put the stop-loss somewhere around the support line. Due to a lot of factors that influence the market, the price went below stop-loss, and only then bounced back and that can happen in a matter of days.
You can notice this phenomenon happening all the time. You can certainly make a profit and that is great. What can happen next? Well, some factors, most influential of them being big banks can decide that that support line you saw is no longer valid, it is basically useless. In other words, the price can go a lot further than you think and you are missing a great opportunity to earn even more. Actually, a lot more.
Most Forex traders used the support line, that we discussed, only for reversals. That is why some Forex experts say that using support lines and ratios is “foolish”. They could have made a lot more profit if they were searching for trends or breakouts. If you are an experienced Forex trader you could notice everything we talked about until now on basically any daily chart.
What we suggest is that you become a trend trader. That is the key to making more profit, and put more money in your pockets at the end of the year. For a more practical part, we will discuss some guidelines on how to do it. First of all, you need to scale out. You take, for example, TP (take profit) of 60 pips. It may sound strange but, when it hits 60 pips you should take half your trade-off. Whatever you stop-loss is, for example, -12 -20 pips, you just move it up so you can break even. So, you just move it to where you went long or went short. Doing this will often bring you some profit. It is a small profit, but it`s something. The key here is to combine your small profit, let`s say “wins” and minimize your losses.
The next question you can ask yourself is why should you do something just to minimize your losses? Isn`t Forex all about profit and earning money? That brings us to a big mistake Forex traders make when using 2:1 or 3:1 ratios. They just cap their upside. They miss out on 600, 800, 1000 pip trends that happen more than once a year.
If you are a trend trader and did everything right, that means you combined all those small “wins” in order to break even and you were able to hop on a fast train called a trend. Now that is how you make a substantial profit.
If you manage to do as advised here, you will get into a position where there will be more times you win than you will lose. Even using the Aroon up and down indicator can show this.
So after reading this, should you use 2:1, 3:1 risk ratios? It is up to you to decide, although you will not be able to ensure you win more than you lose. You should have a scaling out plan, but you should never cap your upside. You are limiting, blocking yourself from making all that profit that other, trend traders take. Trends are where you make money at the end of the year. Like we said they can happen more than once a year at any given pair. So imagine what you can do if you are practicing this on 10-20 pairs, for example.