Increasing Your Risk/Reward Ratio
There’s a common belief, and I believe a misconception, that in order to increase your Risk/Reward ratio, you have to sacrifice your winning percentage. In other words, if you want to hold out for larger wins, be prepared to be stopped-out more and take more losses. Of course, whether you subscribe to this belief or not lies in your own experience as a trader and your trading strategy.
One of the most effective ways I’ve found to increase Risk/Reward whilst maintaining a high win rate is to take into account more than one timeframe when trading.
Let’s take a look at an example: a couple of weeks ago, a standard Engulfing Candle Setup appeared on the GBP/USD Daily chart. (See here for an explanation of the Engulfing Pattern.)
Normally, I would place the trade at the open of the candle after the two-candle pattern, place the stop-loss above the high of the second candle, and take my profit at 1:1 Risk/Reward. In this case, the target, +105 pips, was hit within two bars.
Now, instead of simply placing the trade based on the Daily chart, you can zoom into a lower timeframe to find either a better place to enter or to place a stop-loss. For this trade, I zoomed into the 1-Hour chart:
Now, this is what I saw on the chart: I saw an upward trendline that had been broken and immediately retested from the other side by the next candle after the break. The trendline break is marked by the blue circle. Then the next three candles produced a small continuation triangle (marked by the orange circle) which I interpreted as a continuation pattern or for the new downtrend. (Read more about how I trade trendline breaks here and how I trade triangles here.)
I decided to enter in the same area as I would have if I’d just looked at the Daily chart. But on the hourly chart, I felt confident to place my stop above the trendline and the triangle pattern, about 45 pips away. So instead of a stop-loss of 105 pips, I took the same trade with a stop-loss of 45 pips. This doubled my Risk/Reward to over 1:2. And I believe the trade was just as safe as if I’d traded it with the usual 1:1 Risk/Reward because I had a variety of factors on the smaller timeframe that indicated the price would not move back up in a hurry.
With this trade example, I could see clear reasons for a smaller stop-loss on the lower timeframe. This is not always the case so I don’t just automatically zoom-down and halve my stop-loss! But I always look to the lower timeframe to see if I can find a better entry or exit.
1. You can increase your Risk/Reward by using more than one timeframe to plan your trade.
2. Sometimes, you may just see the trade on a single timeframe and trade accordingly.
3. Increasing your Risk/Reward does not necessarily mean you have to lower your win percentage.