Minimizing Risk and Maximizing Reward-Part 2

Hello guys, this is Nathan Tucci. A week ago I wrote an article called “Minimizing Risk and Maximizing Reward–What a Joke

The idea was that we always hear about minimizing risk and maximizing reward simultaneously, but it is actually a mathematical impossibility. I got a ton of response from the article, and a few things were brought up several times. I wanted to take a minute and respond to those before I began the next section of my article.

There were 3 main things that people argued against my article.

1. It’s just a matter of perspective.

Several people said that it was just a matter of my perspective and that, depending on how you look at it, it could be done.

Well, there are a LOT of things in trading that are totally a matter of perspective and interpretation, but I can’t say this is one of them. The direct relationship between risk and reward (remember that direct relationship means that when one goes down the other goes down and when one goes up the other goes up) is a mathematical principle. It is not my opinion that these things have a direct relationship, it is a mathematically proven truth. So, although I grant that there is room for interpretation in so many things in trading, this has no more room for interpretation than does gravity.

2. A Good Risk to Reward Ratio

I had a lot of people say that if they risk a smaller amount than they are making, then they are minimizing risk and maximizing reward.

This is a good point and I recommend using a good R/R ratio; however, having a larger reward than your risk is not minimizing risk and maximizing reward. Your reward can be ten times as large as your risk, and that is wonderful, but it has nothing to do with minimizing or maximizing. To be obnoxiously technical, you would have to risk 0 percent to minimize risk (as the word minimize comes from the root of minimum or least amount possible) and you would have to risk 100 percent to maximize reward (as maximize comes from the root of maximum or most amount possible).

In other words, I could have a stop loss of 10 pips with a target of 500 pips entering a trade and still have not done anything to minimize or maximize. All I have done is create a nice ratio of risk to reward.

If that ten pip stop loss is risking 5% than my reward would be 250%. 250% on one trade would be nice, but it surely is not maximized. Just think if I risked 10% with the ten pip stop loss, then all of a sudden my reward is 500%. If I maximized my reward and risked 100% on the 10 pip stop loss then my reward would be 5,000%. Now, that is a maximized reward ;), BUT how do we earn 5,000% while minimizing risk??

Well, folks, if I knew the answer to that question, I would be hanging out in my private yacht off the coast of one of the islands I owned, and they’d hanging my portrait in place of Issac Newton and Albert Einstein.

Obviously, I am being slightly over the top to make my point here, but I hope it is making sense to you. I am trying to drive home that we can’t get caught up in the fairy tale of minimizing our risk and maximizing our reward at the same time; trading requires risk and that is something we have to be willing to take on in order to make money in the Market no matter how good our risk to reward ratio is.

3. Support and Resistance Levels change the Odds

I had a few people comment explaining that using certain levels in trading to “Hide your stops” behind change the odds of trading. In other words, a stop loss guarded by a massive resistance level is more secure than one just randomly placed with the same amount of pips. With that in mind, it is possible to minimize your risk by using these levels and still get the maximum reward.

This argument was in response to me talking about the idea that moving your stop loss tighter is also reducing your reward because it is directly affecting the amount of times that reward will be hit. In other words, you are always more likely to hit a target of “x” with a 50 pip stop loss than you are with a 25 pip stop loss, regardless of any other circumstances. It is a simple principle that no matter what your target is, you are more likely to hit it with a larger stop loss than with a smaller stop loss. I am sure most people understand this and agree with it already, but I recorded a video just to show you an example.
 

 

Now, let me get back to this argument about using levels to minimize risk. It is a sound argument because it is true that certain levels have shown significance, but they do not change the principle of the direct relationship between risk and reward. Support and Resistance may increase your probability of hitting the target on a certain trade, but it certainly does not nullify the fact that the probability of hitting a trade is directly affected by how much room you are willing to give it (aka how much risk you are willing to take on). Support and Resistance MIGHT improve your odds, but larger stop-losses MUST improve your odds. So even though you may increase your winning percentage using key levels, you are not defying the direct relationship of risk and reward.

I am not making this point to encourage you to increase your risk, but to clarify the logic behind my statement about the impossibility to decrease risk and increase reward at the same time.

I have responded to the arguments only to make the point that Forex trading (any trading) takes risk. There is no way to cheat the system and make bucket loads of cash without risking anything–that is a fairy tale.

Okay, now that we have settled that, let’s talk about what you can do to make money and still control risk in the Forex market.

First of all, you can implement the things that I just talked about. Having a strategy with a good risk to reward ratio is a great way to trade. Determining how much you want to risk and knowing that any profit you get will be 2 or 3 or 10 times the amount of risk you put forth is a very solid technique to approaching the market. These types strategies are often very difficult to trade because they require A LOT of patience and discipline. The key is finding long term patterns and knowing your rules well before you enter the trade; my friend on twitter, Zaheer, is a pro at this.

Another thing you can do that was also mentioned in the responses to my last article is use key levels in your trading to increase your probability. Sophia Todorova, the Winner’s Edge Live Trading Room host for the London Session, mentioned that you could take an hourly entry at a key weekly or daily resistance level. In this way, you could have your stop (rather tight because of the smaller entry time frame) guarded by a strong resistance area and still be able to target daily or weekly moves in the market. This is an extremely intelligent way to trade for several reasons: it gives you a way to trade with a high reward to risk ratio, it gives you more precise entries, and it guards your stop behind stronger levels than you would find just looking at the 1 or 4 hour charts for levels.

The two techniques mentioned above can be used very effectively and they go hand in hand.

Make note that neither of these techniques are technically minimizing your risk or maximizing your reward, but they are controlling your risk and taking as large of reward as is provided by the risk you are willing to put forth. In other words, if you are trading with a 1:5 risk to reward ratio and you are willing to risk 1%, you would make 5% per trade. If you are willing to risk 4% than you would make 20% per trade.

One thing to understand is that it is very unlikely to have a predetermined risk to reward ratio with a good long term strategy, but I am just putting some numbers out there to show an example of how these techniques can be beneficial.

As mentioned, your results in trading will be directly affected by the amount of risk you are willing to take on. This, of course, does not mean that you should take on a massive amount of risk to improve your returns, but you do need to be aware that you have to take on risk and you will lose trades. Losing trades is perfectly fine. If you have a good system and you are following your rules, than you can take a bad trade and keep on rolling.

Speaking of risk and trading systems, one thing I believe is that an account’s risk exposure should decrease as the account grows larger. If you have a good system like I mentioned above and are willing to follow the rules of the system for a long period of time to grow your account, you should be risking less and less as the account grows in terms of percentage, but you should also be making more and more profit as it grows. This is one of the beautiful things about growing an account. You can risk 2% to make 10% of a 10k account which is a thousand dollar gain; but after you grow your account to 100k, you can risk 1% to make 5% which is 5 thousand dollars. With this type of money management, your account can continue to grow, your profits can continue to compound, yet you will be risking less and less of your account. Now that is AWESOME.

I hope you have gotten something from this article. My goal was to point out the inconsistencies of minimizing risk and maximizing reward, but to explain that there are still ways to keep your risk under control and still take advantage of profit potential in the market.

One thing I tend to believe is that it is okay for a trader to take on more risk on certain trade set ups that they “feel better about.” I know that many people are of the opinion that a good system has very specific rules and one should always take the entries that follow those rules and use the same amount of risk in every entry. I understand that mindset and certainly agree that a trader should have strict rules, but I also tend to believe that after a while of trading a system, a trader begins to develop more confidence in some trades than others. Of course a trader should feel confident in every trade his strategy produces, but I still believe there is some room for extra confidence in a trade.

That is just my opinion, I know that I am more aggressive at times when I think a set up is especially ripe. What do you guys think?

Anyway, thanks for reading and I hope you enjoyed!

Nathan

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  • forexpipalert.blogspot.ca

    I think the important thing when trading is experience of knowing when the market is high probability and low probability.  I usually take trades using 1:2 risk to reward but I also take trades using 1:1.5 or 1:1.  I think risk to reward is all due to probability.  Learning when is high probability, low probability, and when the market changes from high to low probability is key.  This is what changed my trading and made me successful.  Hope that helps!

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  • NathanTucci

    Hi Manana, thank you for all of the good points and for taking the time to read my article and leave a comment.

    I do agree with you that expectancy is extremely important.

    My point about a high reward compared to a low reward not being the same as minimizing risk and maximizing reward just goes back to the fact that you can have smaller risk than reward without maximizing or minimizing one of them. You are only taking the reward that is given by the amount you are willing to risk, you aren’t maximizing it. To maximize the reward you would have to ramp up your risk, which of course would not be minimizing risk any longer.. so I am just pointing back to the idea that the can’t be done at the same time.

    I am surprised that you don’t agree that risk exposure should decrease. In my opinion, though you plan on never having to risk most of the account, it is still wise to have the funds necessary to control any “situations” you might get caught in.

    Thanks again for reading.

    Nathan

  • Manana1

    I offer a scenario that comes to mind. First, let’s assume I scale out of a trade at a target or work behind price for the scale. You are 100% right because I have scaled my potential loss is smaller but so are my potential gains.

    On the surface you are correct, but under an expectancy analysis, say that scaling will boost my profitable trades probability by 15% (arbitrary number), and the difference that not having 15% more losing trades make (negative pips), vs the money that has been lost due to negated gains due to scaling. Perhaps scaling and muting my gains which will minimize my losing trades, over the long run makes me MORE profitable.

    This draws back into my point on your last post about running an expectancy analysis. No decisions about a trade should be made without a thorough statistical expectancy analysis and feasibility analysis of each aspect of a trade and tested thoroughly before implementation.

    I also disagree with your point about reducing risk exposure as your account grows. If you do not desire to grow your risk at the same relative percentage as before which relatively increases your reward, then wire out the extra money. It serves no purpose in the account other than being at risk.

    I do not understand your section 3 argument. If your probability and R/R ratio improve at value areas that is the definition of minimizing risk and maximizing rewards by only taking trade triggers off of those levels. More importantly, again it goes back to expectancy, if you are 80% probable trade but 2 losers eats up 4 winners then it is pointless. But if your probability is 70% and your reward outweighs your risk by say 2.5 then you have the makings of being more profitable. So widening your stop does not at all guarantee improving your odds over the long run.

    Again I may just be confused as to what you are saying under point 3, please forgive if I am mistaken. Also I do see that you are an advocate of a strong R/R ratio approach to trading.

    Nonetheless I enjoyed the read.