To succeed in trading risk assessment is paramount. Most of the stuff I've read on the topic stress the risk reward ratio. eg.. risk 20 pips to gain 60 pips, a R:R ratio of 1:3 (sounds great). Unfortunately this is far too linear, and risk is far more complicated. Risk assessment should also include for example, distance price must move and time given to achieve that move.
So we need to "work out" the probability, that the price we want, will be hit in the time horizon allocated.
An example: ( All numbers are rough guesses, but just serve to illustrate the point )
Profit target Probability of hitting target in 30 mins
10 pips ------------------> 90%
20 pips ------------------> 80%
30 pips ------------------> 60%
40 pips ------------------> 40%
50 pips ------------------> 20%
60 pips ------------------> 5%
Obviously the market type (TREND or RANGE) and currency pair along with a host of other factors will affect these probabilities.
So... according to the above numbers
Risk:Reward of 60:10 = 60x0.05 : 10x0.9 --> 30 : 90 --> 1:3
Risk:Reward of 1:3 (textbook) = 0.9x10 : 0.6x30 --> 9:18 --> 1:2
As you can see from the above calculation, the "larger risk" turned out to be less due to the small profit target.
The bottom line: SMALL TARGETS ARE SAFER AND HIGH PROBABILITY, BUT TO HIT THESE TARGETS STOPS MUST BE WIDER.
Thoughts?
So we need to "work out" the probability, that the price we want, will be hit in the time horizon allocated.
An example: ( All numbers are rough guesses, but just serve to illustrate the point )
Profit target Probability of hitting target in 30 mins
10 pips ------------------> 90%
20 pips ------------------> 80%
30 pips ------------------> 60%
40 pips ------------------> 40%
50 pips ------------------> 20%
60 pips ------------------> 5%
Obviously the market type (TREND or RANGE) and currency pair along with a host of other factors will affect these probabilities.
So... according to the above numbers
Risk:Reward of 60:10 = 60x0.05 : 10x0.9 --> 30 : 90 --> 1:3
Risk:Reward of 1:3 (textbook) = 0.9x10 : 0.6x30 --> 9:18 --> 1:2
As you can see from the above calculation, the "larger risk" turned out to be less due to the small profit target.
The bottom line: SMALL TARGETS ARE SAFER AND HIGH PROBABILITY, BUT TO HIT THESE TARGETS STOPS MUST BE WIDER.
Thoughts?