How The "Leverage-Game" Works

Leverage  and Margin

Margin is defined as the amount of money that is needed as “deposit" to open a position with your forex broker. It is used by your forex broker to maintain your open position. What your forex broker basically does is that takes the margin deposit and lump them with everyone else's margin deposits. It then uses this accumulated “margin deposit" to make transactions within the interbank network.

Margin is often expressed as a percentage value of the full amount of the position. For instance, most forex brokers say they require 2%, 1%, .5% or .25% margin. Based on the margin required by your broker, you can calculate the maximum leverage you can wield with your trading account. Here are the other popular leverage ranges that most forex brokers offer:

Margin Required	Maximum Leverage
5.00%	20:1
3.00%	33:1
2.00%	50:1
1.00%	100:1
0.50%	200:1
0.25%	400:1
0.20%	500 : 1
0.10%	1000 : 1

In addition to "margin required", you will probably see other "margin" terms in your trading platform. These margin terms refer to different aspects of the trading account and they are defined as follow:

Margin required: It is expressed in percentages and is referring to the amount of money your forex broker requires from you to open a position.

Account margin: This is the total amount of money you have in your trading account.

Used margin: This refers to the amount of money that your forex broker has set aside to keep your current positions open. Although the money is still considered yours, you will not be able to use it until your forex broker returns it back to you either when you close your current positions or when you receive a margin call.

Usable margin: This is the money in your account that is available to open new positions.

Margin call: If your open losing positions decreases beyond the usable margin levels set for your account, a margin call will take place and some or all open positions will be closed by the broker at the market price.

The margin is actually used by the forex broker as collateral to cover any losses that you may incur during trading. In actual fact, nothing is being bought or sold for physical delivery to you. The real purpose for having the funds in your account is for sufficient margin.

http://www.learn-forex-trading-basics.com/leverage.html

Why the Risk-to-Reward Ratio is Overrated

Why the Risk-to-Reward Ratio is Overrated

By Walter Peters | TradingMarkets.com | May 26, 2010 08:31 AM

Sometimes axioms are repeated over and over, and that is enough for many to accept them as fact. "No pain, no gain" - really? Would every doctor agree with that? "If it sounds too good to be true, then it probably is" - well, truthfully there are homes selling for $1 now, so maybe that isn't true either.

In trading, one of my favorites is "you must aim to get more profit than you risk on each trade." Sometimes this is stated in other ways, such as:

"Always keep your reward to risk ratio greater than 1"

"Only take trades with a minimum of a 2:1 reward to risk ratio"

"If you aim for more than you risk, then you will make money."

"A good reward to risk ratio ensures you to be profitable, winning more than you lose."

Another way of stating this is that your reward to risk ratio must be greater than 1, or 2, or any other number that your favorite trading guru comes up with. Many traders have heard that it is desirable to have a high reward to risk ratio, and it certainly makes it easier for a trader to make money even if the trader has a low win percentage. However, there are many profitable traders who always risk more than they aim to secure in profits. The key to profitability for these traders is that they keep a high win rate.

An example may best illustrate how the reward to risk ratio is calculated:

Trader Amber decides to buy the EUR/USD at 1.3100

Amber puts her stop loss at 1.3050, so her stop is 50 pips away from her entry.

Amber decides to enter a profit target of 1.3200, 100 pips away from her entry.

Thus, Amber is risking 50 pips to make 100 pips.

If we divide the possible gain by the possible loss, we get the reward to risk ratio.

100 pips profit / 50 pips risked = 2:1 reward to risk ratio

In other words, Amber has decided to keep her profit target further from her entry price than her stop loss. This certainly is understandable, but there are many other ways to make money trading. Keeping a good reward to risk ratio may increase your average win size and decrease your average loss size, but there are other statistics that determine your overall profitability, as a trader.

The most important statistics are as follows:

Percentage of winning trades - W%.
Percentage of losing trades - L%.
Average gain on a winning trade - Ave W.
Average loss of a losing trade - Ave L.

Here's why these statistics are important - with just these four statistics you can find out how good your trading system is, and thus decide if it is worth it to trade the system with real money. With these four statistics you can calculate expectancy of your trading system.

The formula is as follows:

Expectancy = (W% x Ave W) - (L% x Ave L)

The expectancy number tells you how much money you would expect to win over many trades. The best way to get these statistics is to backtest your trading strategy, or employ your trading strategy with a demo account. Do this for many, many trades (at least 50), and then plug in the numbers.

Let's look at a trader, Jeff, as an example:

Let's say that trader Jeff has a trading system that he backtests manually in a demo account for six months, with over 900 trades, and he gets the following statistics.

W% - 70%

L% - 30%

Ave W - $200

Ave L - $420

Calculating expectancy, Jeff sees that (0.7 x 200) - (0.3 x 420) = $140 - $126 = $14. So, armed with this information, trader Jeff knows that if he takes 100 trades with his system, and the average winning trade is $200, and the average losing trade is $420, with a 70% win rate he is likely to have 70 winning trades, 30 losing trades and he will probably make $1400. How does Jeff know this? He knows this because he knows that (70 x $200) - (30 x $420) = $14,000 - $12,600 = $1,400.

This doesn't mean trader Jeff will make $1,400. This only means that we would expect him to make $1,400 over 100 trades. Of course Jeff's real results could be a little better or a little worse, but they are probably going to be very near $1,400 after 100 trades.

Many traders, including myself, have gotten into trouble by simply focusing on one part of the equation.

Traders who focus on win rate and forget about average loss size can get into trouble if their average loss gets too big.  This is the sort of problem that many scalpers run into. Scalpers count on a high win rate. Without a high win rate most scalpers will lose money. This is because nearly every scalper, by definition, will look to take quick profits from the markets, however the scalper will often have a stop loss that is placed further away than the profit target, and this can spell trouble if the win percentage starts to slip. Some scalpers avoid this problem by letting some positions run for a while if they are exceptionally well-timed entries. This will dramatically increase the scalper's average win and can really improve the odds of the scalper's long term survival.

Traders who focus on average win size can get into trouble if they let their win rate get too low.
This problem is common with those traders who are focused on the reward to risk ratio. Sometimes traders become "slave to the reward to risk ratio." Profit targets should be placed where the market is likely to go. Traders who focus too much on the reward to risk ratio can avoid this problem by defining profit targets using sound market analysis, and THEN calculating the reward to risk ratio.

There are many things to think about when backtesting your trading system - the reward to risk ratio will tell only part of the story. If you have a trading system that you think may work, backtest the strategy, and then calculate the expectancy. You may find that that the strategy makes money, even if the reward to risk ratio is not ideal.

Walter Peters, PhD is a professional forex trader and money manager for a private forex fund. In addition, Walter is the co-founder of Fxjake.com, a resource for forex traders. Walter loves to hear from other traders, he can be reached by email at walter@fxjake.com.

http://www.tradingmarkets.com/.site/forex/how_to/articles/Why-the-Risk-to-Reward-Ratio-is-Overrated-80805.cfm

Calculating a Stock’s Risk-Reward Ratio by Jim Cramer

Calculating a Stock’s Risk-Reward Ratio
Published: Tuesday, 30 Aug 2011
By: CNBC.com


Focusing on a stock’s upside without giving proper consideration to potential losses, Cramer said Tuesday, can be “a grave mistake.” Too often people think only of the reward, without assessing the risk. And investors must calculate both.

“Because the pain from a big loss,” Cramer said, “hurts a whole lot more than the pleasure from an equivalent-sized gain.”

But how do you figure out the risk-reward on a stock? As a general rule, Cramer looks at the lowest price that a value-oriented money manager would pay for that stock to calculate the downside. For the upside, he uses the most a growth-focused manager would pay.

To arrive at these numbers, Cramer refers to something called “growth at a reasonable price,” or GARP, a method of stock analyzing first popularized by Peter Lynch. If you want to know just how much growth investors will pay, you need to understand GARP. And it involves a comparison of a stock’s growth rate to its price-to-earnings multiple.

But you can use this rule of thumb to figure out the value side of the equation, too, and here’s how Cramer does it: If a stock has a price-to-earnings multiple (PE) that’s lower than its growth rate, it’s probably cheap. And any stock that’s selling at a multiple that is twice the size of its growth rate or greater is probably too expensive and should be sold.

Example: A stock trading at 20 times earnings with only a 10 percent growth rate would be considered expensive. But the reverse—10 times earnings on a 20 percent growth rate—would be incredibly cheap.

This gives rise to another piece of Wall Street jargon: the PE-to-growth ratio, or PEG, which is the multiple divided by the stock’s long-term growth rate. A PEG of one or less is “extremely cheap,” Cramer said, while a PEG of two or more is “prohibitively expensive.”

This means then that the risk floor created by value investors will probably be somewhere near a stock’s PEG of one, while its ceiling, created by growth investors, rarely exceeds a PEG of two. That’s why Google [GOOG  570.11    -9.89  (-1.71%)   ] back between 2004 and 2007 was considered cheap, because its 30 percent long-term growth rate matched its 30 multiple. But if that multiple reached 60, growth managers would probably cash out of their positions.

There is one caveat to keep in mind, that this is a general rule of thumb, an approximation. But there are times when the numbers can be wrong. Cramer said stocks can look cheap based on earnings when those earnings estimates need to be cut, much like the banks and brokers were ahead of the 2008 crash. Or a stock could look cheap because its growth is slowing, like Dell[DELL  14.30    -0.53  (-3.57%)   ] after the dot-com collapse between 2000 and 2003. In these cases, the stock could trade well below a PEG of one, but that obviously doesn’t mean it’s a buy.

One final anomaly of multiples regards industrial companies, or cyclical names in general. The time to buy these stocks is when their multiples look outrageously high, Cramer said, because the earnings estimates are too low and read to be raised to catch up with their strengthening businesses.

(Written by Tom Brennan; Edited by Drew Sandholm)

http://www.cnbc.com/id/44334471/Calculating_a_Stock_s_Risk_Reward_Ratio

How are you dealing with the risk reward ratio?

Do you check out your risk reward ratio before placing a trade? Good. But do you stretch the stop loss or take profit points just to fit the desired ratio? Not so good.

Here are some common mistakes regarding the risk reward ratio, and some tips on how to do it the right way.

A risk-reward ratio in forex is the number of pips that you risk if the price reaches the stop loss point, versus the number of pips that you’ll gain if the price hits your take profit point.

Optimally, the reward side should be 3 times the size of the risk side. Also 2:1 is OK. A better ratio means in theory that less winning trades are needed in order to be a profitable trader. This is assuming that you don’t take the profit before it hits the take profit point, and hopefully you aren’t moving your stops, which is far more dangerous. Don’t move your stops!

So, now you are aware and incorporate this factor into your system. Great!

The problem begins when you are itching to trade. This happens to many traders, too many times. So, you use your system to find a potential trade. And now you make the simple calculation of the risk-reward ratio. And unfortunately, it falls short of your target.

What do you do?

Squeeze your stop loss: Wrong. This will improve the ratio, but if the pair doesn’t go in your direction soon enough, it will hit your stop loss soon enough. You’ve ensured your loss.

Widen the take profit point: Wrong. This will improve the ratio as well and has a lower chance of hitting the stop loss too soon. But if your system was good before incorporating the risk-reward ratio, the price has low chances of hitting the take profit. The wind needs to blow in your direction very strongly.

Walk away: This is the right thing to do. Your system got a nice setup, but the ratio was poor. Just walk away. This trade just isn’t good enough. Other trades that fit your system AND provide a good risk-reward ratio will come along.

How are you dealing with the risk reward ratio?

Read more here:  http://www.forexcrunch.com/dont-risk-your-reward/

How to Use Risk-Return Ratio

How to Use Risk-Return Ratio

What is the best Risk-Return Ratio? The largest of course! But the minimum Risk-Return Ratio absolutely necessary will vary for each trader. To determine the Risk-Return Ratio that will increase your profitability, ask yourself this question:

What percentage of the time are my trades successful?

If your answer is 50%, you only need a Risk-Return slightly higher than 1:1. If your trades are only successful 20% of the time, you need at least a 1:4 Risk-Return.

As a general rule of thumb, it is very difficult to achieve a winning rate greater than 50%. Therefore, most profitable traders aim for Risk-Return trades that are 1:2 as an absolute minimum, while 1:3 or 1:4 is strongly suggested.

http://www.onlineforextrading.com/learn-trading/risk-reward-ratio

A good risk/reward ratio is able to make an unprofitable system profitable, while poor risk/reward ratio can turn a winning setup into a losing strategy.

Risk/reward ratio is one the most influential parameters of any Forex system.
A good risk/reward ratio is able to make an unprofitable system profitable, while poor risk/reward ratio can turn a winning setup into a losing strategy.

What is risk/reward ratio?

Risk - simply referred to the amount of assets being put at risk. In Forex it is the distance of our Stop loss level (in pips) multiplied by the number of lots traded. E.g. a stop loss at 50 pips with 2 lots traded would give us a total risk of 100 pips.

Reward - the amount of pips we look to gain in any particular trade - in other words the distance to a Take Profit level.

Example of risk/reward ratio:

100 pips stop vs 200 pips profit goal gives us 1:2 risk/reward.
25 pips stop vs 75 pips profit gives 1:3 risk/reward ratio.

http://forex-strategies-revealed.com/money-management-systems/risk-reward-ratio

What Is the Proper Risk and Reward Ratio in Forex Trading?

Risk/Reward Ratio in Forex - What Is the Proper Risk and Reward Ratio in Forex Trading?

The solution is in moving the stop loss. You should not let your stop loss remain at its initial position. To have a 1:3 trade, the distance of your entry and your final target should be splitted into 3 parts (at least), while each part is equal to your original stop lossvalue. For example if you have a 50 pips stop loss, you should have a final target for 150 pips which should be splitted into three 50 pips levels. Then you should move your stop loss in three stages (in this example I assume that you take a 3% risk in each trade):

1. If the price reaches to the first 1/3 level, you should move the stop loss to breakeven. At this stage, if the price goes against you and hits the stop loss, you will get out without any profit/loss, BUT you should consider that you had an initial risk of 3%.

2. If it reaches the 2/3 level, you should move the stop loss to 1/3 level. At this stage, if the price goes against you and hits the stop loss, you will get out with a profit which equals your initial risk. For example if your stop loss has been 3% of your account, you will get out with a 3% profit. Therefore, such a trade will be ended as a 1:1 risk/reward trade.

3. If it becomes so close to the final target, you should move the stop loss to 2/3 level. Then you have to wait until it hits the finaltarget or returns and hits the stop loss. At this stage, if it goes against you and hits the stop loss, you will get out with a profit which is twice of your initial risk. For example if your stop loss is 3% of your account, you will get out with a 6% profit. Therefore, such a trade will be ended as a 1:2 risk/reward trade. If the price hits the final target, your trade will be closed with a 9% profit and so you will have a 1:3 risk/reward trade.

So, to have a 1:3 trade, you will have some -3% trades which are those trades that hit the stop loss at its initial position. You will also have some 0% trades that are those trades that hit the stop loss at breakeven. Some of your trades will be +3% trades which are those that hit the stop loss at 1/3 level. Some will be +6% trades which are those that hit the stop loss at 2/3 level. And finally, some trades will be +9% trades which are those that trigger the final target.

Now the question is what percent of your trades will be -3%, 0%, +3%, +6% and 9% trades?

It is impossible to answer the above question, because it depends on many things including the trading strategy and market condition. 

Read more here:

http://www.forexoma.com/what-is-the-proper-risk-and-reward-ratio-in-forex-trading/

Please note that forex and other leveraged trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved.

What is Risk Management? You want to be the rich statistician and NOT the gambler.

What is Risk Management?

This section is one of the most important sections you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses).

Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regard for their total account size.

They simply determine how much they can stomach to lose in a single trade and hit the "trade" button. There's a term for this type of investing....it's called...

GAMBLING!

When you trade without money management rules, you are in fact gambling.
You are not looking at the long term return on your investment. Instead you are only looking for that "jackpot".

Money management rules will not only protect you but they can make you very profitable in the long run. If you don't believe us, and you think that "gambling" is the way to get rich, then consider this example:

People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win.

So how in the world are casinos still making money if many individuals are winning jackpots?

The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don't win. That is where the term "the house always wins" comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money--not the gamblers.

Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON'T win that jackpot and the money will go right back in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses. Essentially, this is how money management works. If you learn how to control your losses, you will have a chance at being profitable.

In the end, Forex trading is a numbers game, meaning you have to tilt every little factor in your favor as much as you can. In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser.

You want to be the rich statistician and NOT the gambler because, in the long run, you want to "always be the winner."

So how do you become this rich statistician instead of a loser?

Read more: 

http://www.babypips.com/school/what-is-risk-management.html#ixzz1ebTZDg9e

Risk reward ratios are a critical component to successful trading but does not guarantee success.

Risk reward ratios are a critical component to successful trading. Trading can quickly become gambling if you continue to press your bets by taking positions with poor risk reward ratios. While identifying good risk reward ratios does not guarantee success, ignoring them usually guarantees failure.

Candlestick traders look for patterns with proven higher probabilities for placing trades. Once the pattern is identified, the next step is determining entry and exit points. For both, profit targets and stop loss targets. These points can be determined based upon moving averages, Bollinger bands, or other technical indicators to evaluate possible support and resistance levels. The onslaught of computerized trading programs provides traders with quick calculations to base one’s risk/reward targets.

Calculating Risk Reward Ratios

Let’s assume our computerized scanning program provides us with a dozen high probability patterns from which to choose. Most traders will only be able to add one or two new positions to their portfolio. This is where utilizing risk reward ratios come into play.

The simplest calculation will take into account:

1) Entry Price

2) Profit Target

3) Stop Loss Target 

For example:

Stock XYZ has the Entry Price of $20.35 with our Profit Target of $21.50 and Stop Loss target of $19.85.  Our Risk = the difference between our Entry Price of $20.35 and our Stop loss of $19.85 or Risk = .50.  Our Reward is the Entry Price of $20.35 plus the Profit Target of $21.50  or Reward = $1.15. We are risking .50 to make $1.15. In this example a little better than a 2:1 ratio.

The rule of thumb for a reasonable risk reward ratio is a minimum of 2:1. It is important to analyze your potential loss in the event your analysis is wrong and the trade does not follow in the expected direction. And, no fair setting your targets using fuzzy math! The risk reward ratio is meant to provide an unemotional evaluation before risking your hard earned money. Don’t ‘jiggle’ the figures to justify the trade.

Use this approach to narrow down your trades until you find the highest probability patterns with the greatest risk reward ratio. The more systematic you become in evaluating your trades the more likely your portfolio will prosper. Additionally, this approach helps to remove emotional trading which is a continued struggle for many investors.

Where to Begin

Evaluate your previously closed positions, using both your winning and loosing trades. Since you should constantly be evaluating your previous trades to evaluate the success of yourmost important technical analysis tools, you will kill two birds with one stone. Yes, I realize this is a boring exercise but it is essential to your success. The old adage ‘Insanity is doing the same thing over and over again but expecting a different outcome’ was never more true. At least take the time to consider whether you want to add the risk reward ratio to your trading criteria.

There is another other element to consider after the risk reward ratio has been determined. What is the length of time you expect to be in the trade? The shorter the time period the more trades you can place and the more money you can make. A 5:1 ratio is less attractive if your opportunity money will be tied up for too long a period. You must use your capital on the highest probability trades. Using the simple risk reward ratio should produce more profits to your portfolio.

To summarize; you should be willing to risk $1 to make $2. You should not be willing to risk a $1 to make a $1. Keep it simple and keep your targets honest, (the data is only as good as the person plugging in the figures).

By doing the risk reward calculations for every potential trade you will have your exit criteria before placing your trade. This keeps you from getting greedy when your profit target has been reached. You can take your profit and re-enter if the new trade meets your criteria. This also helps you from dropping your stop-loss, in the hopes that your trade will soon go your way.

What if I determine one of my open positions has a poor ratio?

Over the years, I have found one of the best ways to evaluate if it is time to take a loss is to look at my existing trade as if I were considering placing it today. If I could not justify taking it at the current price, using the same criteria I use for entering a trade, then it is time to take a loss. If you would not buy it today then more than likely, you already know the answer. Allowing your losses to grow is not a good habit to get into. Hoping and praying are not profitable stock market trading tools. The key is to win more than you lose. Loses are simply the cost of doing business. Every business has an income and expense allowance andcandlestick stock trading is no different.

http://www.candlestickforum.com/blogs/2006/07/risk-reward-ratios.html

Reward-to-Risk Ratio

Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:

10 Trades	Loss	Win
1	$1,000
2		$3,000
3	$1,000
4		$3,000
5	$1,000
6		$3,000
7	$1,000
8		$3,000
9	$1,000
10		$3,000
Total	$5,000	$15,000

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.

BUT...

And this is a big one, like Jennifer Lopez's behind... setting large reward-to-risk ratio comes at a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios.

Let's say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio, this means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread.

If your broker offered a 2 pip spread on EUR/USD, you'll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate of EUR/USD could move 3 pips up and down within a few seconds, you would be stopped out faster than you can say "Uncle!"

If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips. By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right?

In the real world, reward-to-risk ratios aren't set in stone. They must be adjusted depending on the time frame, market environment, and your entry/exit points. A position trade could have a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1.

If you want a real world example of traders trying to maximize reward-to-risk ratios, you should check out Pipcrawler's Pick of the Day blog and Cyclopip's Weekly Winner. Pipcrawler normally takes trade setups that have at least 2:1 ratios, while Cyclopip pinpoints the best setups from the previous week that would have maximized his profits.

Read more:

http://www.babypips.com/school/reward-to-risk-ratio.html#ixzz1ebPybKrS

The risk/reward ratio is a lie. It is a fun fantasy,

Risk-Reward

Apples and Unicorns; The 'Risk/Reward' Ratio ...is a LIE (unless you're an unusual kind of trader). 


The risk/reward ratio is a lie. It is a fun fantasy, but because one of its components has a horn, it does not exist. If a salesman calls you up (I won't even call him or her a broker) and tells you he has a dynamite trade in Wheat, as evidenced by the risk/reward ratio of 8 to 1 profit to risk, just say no. It is NOT real. Take that trade only if there is something else out there that's convincing.


Don't compare the risk/reward ratio (i.e. don't take the expected risk on a trade and comparing it to the expected return) - use the risk/account ratio instead (i.e. the amount you're risking to the amount in your account).


Read more here:
http://www.financial-spread-betting.com/Risk-reward.html