Thread: The 2/1 risk/reward MYTH...

I have discovered some forex traders here in the forum naively believe that the very best and only way to generate money in the forex market is to exchange with a 2/1 risk/reward or better, meaning for every dollar that you risk on each trade you return two or more.

That is of course a myth and here is the reason:

A roulette in the casino provides you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So that your risk here is just $1 but your profit (if your number comes up) is $35, a very good risk/reward scenario indeed.

However, does it mean you will get filthy rich because this is a fantastic risk/reward bet? Of course not! In fact keep playing with this way long enough and you are going to wind up in the home later or sooner, because of the built-in mathematical advantage of the casino. This is by the way the SAME mathematical advantage that every forex broker owns on each trade (bet) you're beginning, because of their 3 to 5 pip spread. That is why many forex traders (like casino players) wind up losing their money in the long term, even if they are right about the direction of the market 50% of their time!

So in conclusion it does NOT matter if you're trading with a 2/1 or 2000/1 risk/reward, the ONLY WAY to earn money in the forex (or futures, stocks, etc.. .) Is to get a STATISTICAL EDGE.

Quite simply your entry and exit points should BEAT pure random entry/exit points.

The way I've always understood it presented is that the risk/reward ratio is significant in combination with your winning percentage. You can't build a system without taking both into account.

In my view when you trade, you don't trade agains your broker(like at a casino),the broker is an intermediator, and the spread is theyr winning(profit you'll be able to state ). Brokers don they wan't to have a major variety of trades, so they can take profit from this spread. Forex traders don't loose money agains brookers(like a casino player at a casino), they loose it contrary to other traders.
I'm wrong or I did not understand what you're saying?

Originally Posted by ;

I've discovered that some forex traders here at the forum naively believe that the best and only way to generate money in the forex market would be to trade with a 2/1 risk/reward or greater, meaning that for every dollar that you risk on each trade you get back two or longer.

This is of course a myth and this is why:

A roulette at the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So that your risk here is just $1 but your profit (if your number comes up) is $35, an excellent risk/reward scenario really.

However, does it mean you will get filthy rich because this is a good risk/reward wager? Of course not! In fact keep playing this way and you are going to end up in the house sooner or later, due to the advantage of the casino. This is by the way the SAME mathematical advantage which every forex broker owns on each trade (bet) you are initiating, due to the 3 to 5 pip spread. That is why many forex traders (such as casino players) end up losing their money in the long term, even if they're about the management of the market 50% of the time!

So in conclusion it does NOT matter if you are trading with a 2/1 or 2000/1 risk/reward, the ONLY WAY to earn money in the forex (or futures, stocks, etc.. .) Is to get a STATISTICAL EDGE.

In other words your entrance and exit points must BEAT pure random entry/exit points.

Your perplexing random entrance with applying a border to greater than average opportunities. What is meant by this is that you find your advantage and apply it to the top opportunities on the market, meaning opporunities yielding over a 1:1 risk to benefit. In case you have don't you think it would be significant to get better than a 1:1 on this trade? If your system has a 70 percent likelihood of being right then you might not hold to the rule that is higher than 1:1. Make sense?

FXT,

You make a fantastic point, however, your logic is faulty.

Risk Reward goes hand in hand with expectancy. This is the part that you're leaving out. 35/1 does you no good if your expectancy is 1/37 (as it is in a double-zero roulette wheel). . .your COMBINED RR is less than 1. This is an point as your expectancy.

Using a 2/1 RR, you need to get an expectancy higher than 1/3 in order to be profitable (you want to acquire once for every two losses to break even).

SO. . .don't confuse the math here. RR is essential but you absolutely need to understand your most common expactancy (which could be difficult to figure out since expactancy is affected by random variables ). This really is why the sport is difficult, since the random nature of the world (let alone the market you're analyzing) can give you all the information in the world, however your expactancy can still be less than you would expect.

Originally Posted by ;

I've discovered that some forex traders here in the forum naively think that the very best and only way to generate money in the forex market would be to exchange with a 2/1 risk/reward or better, meaning for every dollar that you risk on each trade you return two or even more.

This is of course a myth and here is the reason:

A roulette in the casino gives you a 35/1 risk/reward situation, every dollar you wager could bring you $35. So your risk here is just $1 but your profit (if your number comes up) is $35, an excellent risk/reward scenario indeed.

However, does this mean you may get filthy rich since this is a fantastic risk/reward bet? Of course not! In fact keep playing this way long enough and you will end up in the house sooner or later, due to the casino's benefit. This is by the way the SAME mathematical benefit which every forex broker owns on each trade (wager ) you're beginning, due to their 3 to 5 pip spread. That's why most forex traders (like casino players) end up losing their money in the long term, even if they are right about the management of the market 50% of their time!

So in conclusion it doesn't matter if you're trading with a 2/1 or 2000/1 risk/reward, the only means to make money in the forex (or futures, stocks, etc.. .) Is to get a STATISTICAL EDGE.

In other words your entry and exit points should BEAT pure random entry/exit points.

Dismissing the 1/2 risk reward ratio is a flawed argument. Trading in forex is very different than playing roulette or playing lotto. The odds of winning is small with gambling.

But from the financial markets, although nobody can forecast the market, you've got sufficient advantage from fundamental and technical analysis to get you on the winning side given that you adhere to a certain method with consistency. And the simple fact that every trade is a opportunity, you make sure you'll be statistically ahead by receiving the rewards with your initial risk on every trade.

For this reason I believe that transactions that only utilizes benefit to risk of less than 2, could potentialy direct one to destroy or breakeven in the long run. You have to get a system that is winning percentage to take advantae of 1 to 1 risk to reward ratio. And from what I read from Van Tharp and other books, most prosperous traders earn money from less than half of their transactions (lt;50%).

Originally Posted by ;

FXT,

Risk Reward goes hand in hand with expectancy. This is the part that you're leaving out. 35/1 does you no good if your expectancy is 1/37 (as it is in a double-zero roulette wheel). . .your COMBINED RR is less than 1. This is an point as your expectancy considerably lower.

You are of course completely right, you and other members before you in this thread: Risk/reward ratio and winning percentage (and/or mathematical expectancy if you like ) are always related.

But that's precisely what I was saying and nothing else!

Allow Me to clarify with an example. In case you choose to trade using a 2/1 RR (Risk/Reward) ratio, then your winning percent MUST mathematically be greater than 33% if you want to make money. More than 25% winning percentage etc are needed by A 3/1 RR ratio.

But like I was saying, this RR ratio does NOT matter at all. You could do the reverse, for example you could risk 100 pips on a trade to make 10 pips and end up making tons of cash in the future if your winning percentage is large.

Quite simply your entry/exit points must simply beat random entry/exit points, regardless of your own RR ratio or winning percent.

Originally Posted by ;

You are of course completely right, you and other members prior to you in this thread: Risk/reward ratio and winning percentage (or mathematical expectancy if you prefer) are always connected.

But that's exactly what I had been saying nothing else!

Let me clarify with an example. In case you decide to trade with a 2/1 RR (Risk/Reward) ratio, then your winning percent MUST mathematically be greater than 33 percent if you would like to create money. Greater than 25 are needed by A 3/1 RR ratio.

But like I was saying, this RR ratio does NOT matter in any way. You could do the reverse, for example you could risk 100 pips on a trade just to create 10 pips and still end up making a lot of money in the future if your winning percentage is large enough.

In other words your entry/exit points must simply conquer random entry/exit points, irrespective of your own RR ratio or winning percent.

So what is your purpose? It matters when it matters but not when it doesn't? I guess I am missing the lesson.

Originally Posted by ;

Due to this I feel that trades which only uses benefit to risk of less than 2, could potentialy lead one to ruin or breakeven in the long term.

Again, this is a fantasy my friend, a fantasy with no mathematical justifiion whatsoever.

Originally Posted by ;

You need to get a system that's always 60-70% winning percentage to take advantae of 1 to 1 risk to reward ratio.

Noyou might have a system that's winning 0.1percent of the time and make millions in case your entry/exit points always offer you a definitive statistical edge.

Originally Posted by ;

So what's the point? It matters when it matters but not if it doesn't? I guess I'm missing the lesson.

The point is this: do NOT trade only because you like the Risk/Reward ratio, the risk/ratio alone is totally meaningless, commerce because your entry/exit points offer you a mathematical edge.

Of course this mathematical edge itself could only be found during testing, but that is another story.