“Is 30 pips a good stop?”
“Should I use 50 pips as my target?”
“Your risk/reward ratio should be at least 3:1.”
These are some of the types of questions and statements I see in trading forum discussions on a pretty regular basis. New traders are always asking about the placement of stops, how much profit they should be taking from a trade, what a good risk/reward ratio is and all of that. Usually they are doing it in isolation, without considering the big picture.
Let me make a few statements of my own.
A good stop allows a trade sufficient room to handle normal price volatility.
How far away that is from your entry point depends on things like your trading timeframe and your trading methodology. No one can specifically tell you where that stop should be, unless they are trading the exact same way you are. New traders have a tendency to put stops too close because they think that means they are being less risky when in fact they are probably increasing their loss % and thus making their trading more risky.
There is no such thing as a stop that is “too wide”.
I see traders make statements like “I don’t want to risk 150 pips. That’s too much.” This completely misses the point. Your risk is defined by your trade size in conjunction with how far away you place your stop, not just your stop. If you need a “wide” stop, then trade smaller.
The Reward/Risk ratio is meaningless if you don’t know the Win%
Traders have a bias toward high R/R ratios. They think bigger is better. On the face of it, they’re right, but it’s only part of the equation. The R/R can only really be applied meaningfully in conjunction with the Win %. A system with a 4:1 R/R can be a loser (imagine a 20% win%) while a system with a 1:1 R/R can be a big winner (imagine a 70% win%). The two go hand in hand. If you have a low win % you need a high R/R. If you have a higher win%, then a lower R/R is fine, and in fact is probably all you’re going to get. If you’re winning at 75% and waiting only for 3:1 R/R trades then you are practically giving away profits.
Stops and Targets and Reward/Risk ratios are generally speaking not things you can just pick. They need to come from somewhere. That is, usually, your trading system. In particular, R/R is a metric like win % and average drawdown and all of that, not a variable for you to input. My advice to new traders is that they should spend a lot of time trying out different types of trading systems (ones which fit in with their overall trading plan, of course) to see what the metrics from them look like by way of comparisson. The more of this you do, the better you will understand the way systems work and by extension how the market works.
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About the Author
John Forman, author of this blog, has traded for more than 20 years, is a professional market analyst, and authored The Essentials of Trading. He is an active participant in trading forums, consults for trading related businesses, as published literally dozens of trading articles, and has been quoted in a number of books and in the media.
** See John’s full bio.
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