By: Sam Eder
Most traders believe that in order to have a great risk reward ratio on their trades, they need to have a tight stop – or at least as tight as possible.
This makes sense of course. If you risk 30 pips to gain 300 pips, your risk reward ratio is better than if you risk 150 pips for the same 300 pips (10:1 vs 2:1). The tighter the stop, the better the risk/reward. Of course, the tighter the stop, the more you get stopped out, the more losers you have, and the more difficult your trading system is to trade without mistakes.
There is a different way, though – a way in which you can have a wide stop-loss and still have an extremely good risk/reward ratio.
But first, a brief detour into the psychology of stop-losses and the need to be right.
The unnecessary preoccupation with being right
Most traders are obsessed with being right. Many won’t think that they are – they are willing to take losses which traditionally people who want to be right struggle to do. But when they actually trade they are trying desperately to be correct on their entries.
Think about it. If you have a tight stop loss, you do by definition need to be very accurate with your entry level. Otherwise you will get stopped out. Probably, you focus much of your energy on analysis techniques before you get into the trade.
(By the way, I know this is true. I see all the stats about my blog posts. The ones about entries are some of the most popular – even if they are no more important than any other topic.)
Instead, wouldn’t it be great if you could trade without having to be right? Well, if you know how to have a wide stop-loss and still have a good risk/reward ratio, you can.
The funny thing is: the more I have integrated this mindset into my trading, the more winners I’ve had. Probably because my stops are wide.
No fancy techniques here
This is not a fancy method. It’s very simple, and technically easy to apply (although possibly harder psychologically).
Using this technique, you can turn a trade that might have a risk reward ratio of 3:1 into a trade with a risk reward ratio of 10:1 or greater. With no extra risk.
I am a longer term trader, but I have used this on 15 minute charts to good effect. Feel free to adapt it to your trading style. On the shorter-term timeframes, you may want to have an even wider stop-loss (relatively speaking).
So here’s how it works. Let me use an example of a longer-term trade on the EURUSD.
On this trade, we are looking for 1000 pips with a 300-pip stop-loss, giving a risk/reward ratio of 3.3:1. Let’s see how this trade was converted into one that could generate 15 times our risk or more (a risk reward of 15:1).
Firstly, you still want to stalk a good entry. It will improve your success rate and the risk/reward even more. Preferably, you also want a catalyst that triggers the trade.
When you get your entry signal, establish your initial position as you would normally – but make sure you keep your stop-loss well out of the way of any noise. Try tripling what you normally use.
(By the way, another benefit of this approach is that you can tend to trade larger positions, as the quality of your trades goes up. This means your profits can be greater.)
As the market goes for you, scale in to an additional position. You will want it to have gone another 100-150 pips. Preferably, you want to stalk another good entry point for the new position.
When you add the additional position, combine the stops and move them up jointly so that you are risking no more than the original amount of money. I.e. if you were risking 2% of your account, then move the stop up so that you are still risking no more than 2% on the combined position.
As you had some profit from the first position, you will still be able to maintain a wide stop, even though your position size is twice as large. If you set a new profit target for 1000 pips on the additional position, they you have the same risk of 2% of your account, but you stand to make an additional 3.3R on the trade. Your risk reward is 6.6:1 now.
You can put the profit target on the second position at the same place as the original position if you like. But having only one profit target is trying to be right about the exit. Better to have multiple targets, and other exit rules that cater for changing market conditions (not all trades go as swimmingly well as this one).
Once you have added the second position, keep adding as the price goes for you until you reach your maximum position size. For example, on a trade like this, you might look to add up to five positions as it goes for you. Each new position gives you an additional 3.3 to your risk reward, without increasing your maximum risk of 2% of your account.
This is what I call trade implementation. You are not simply looking for an entry. You are anticipating a move, and building a plan that minimises the risk and maximises the reward if the expected move does happen. There’s a monumental difference in the psychology.
Of course, there are some intricacies with this approach, and on occasion you may have to give back a good chunk of the profit you have made on a position (though there are ways to minimize that). There are also lots of different ways you can adjust this method to suit your psychology.
(See the course below for more in-depth lessons.)
Over to you…
Learning how to apply an approach like this is a continual process of testing and practice with your own trading system.
When you take the time to improve your implementation and increase the risk/reward ratio on your trades, you will find that all of a sudden you have more winners, and they are much bigger than you thought possible – so persist through the learning curve.
How will you apply this lesson to what you do?
About the Author
Sam Eder is a macro currency trader and co-owner of FX Renew, a provider of premium Forex signals from ex-bank and hedge fund traders. He is author of the Advanced Forex Course for Smart Traders.