Risk and reward
What you learn in 3 minutesRisk and reward is the comparison between what a position risks if the stop is hit and what it aims to gain if the target is reached. On a standard lot of AUD/USD, one pip is worth 10 units of the quote currency, which at a rate near 0.6640 is about A$6.64. This lesson shows what a chosen ratio does to the share of trades that must work before a series of trades ends in front.
A ratio of 1 to 2 across 10 trades
| Step | Amount | Note |
|---|---|---|
| Stop distance | 20 pips | the distance from entry to the protective stop |
| Target distance | 40 pips | the distance from entry to the target, twice the stop |
| Value of one pip | A$6.64 | 10 units of the quote currency at a rate of 0.6640 |
| Loss when the stop is hit | A$132.80 | 20 pips multiplied by A$6.64 |
| Gain when the target is reached | A$265.60 | 40 pips multiplied by A$6.64 |
| Trades in the series | 10 | a chosen count for the arithmetic |
| Winners at a 40 per cent hit rate | 4 | 40 per cent of 10 trades |
| Losers at a 40 per cent hit rate | 6 | the remaining trades |
| Total from the winners | A$1,062.40 | 4 trades multiplied by A$265.60 |
| Total from the losers | A$796.80 | 6 trades multiplied by A$132.80 |
| Net result of the series | A$265.60 | A$1,062.40 minus A$796.80 |
The broker may round pip values, charge a spread on entry and exit, and add commission or a swap on positions held overnight. Any of these changes the figures above, and the amounts vary between brokers.
The mistake people make here
The common mistake is to assume a favourable ratio can always be found on the chart, so the arithmetic is treated as a promise. A ratio of 1 to 2 means the target sits twice as far from entry as the stop, and price does not always offer that distance before the stop is reached. Instead, measure the ratio from the levels the chart actually shows, and treat the hit rate as something only past results can estimate. A ratio that looks attractive on paper can still lose money if the stop is placed where price regularly reaches it.Check yourself
With a stop of 20 pips and a target of 40 pips, what is the ratio and what does one pip pay on a standard lot of AUD/USD at 0.6640?
The ratio is 1 to 2. One pip is 10 units of the quote currency, which at 0.6640 is about A$6.64.
If 10 trades are taken at that ratio and 4 win, what is the net result in A$?
The 4 winners gain 4 x 40 x A$6.64 = A$1,062.40. The 6 losers lose 6 x 20 x A$6.64 = A$796.80. The net result is A$1,062.40 minus A$796.80 = A$265.60.
What happens to the net result if the hit rate falls to 30 per cent over the same 10 trades?
Three winners gain 3 x 40 x A$6.64 = A$796.80. Seven losers lose 7 x 20 x A$6.64 = A$929.60. The net result is A$796.80 minus A$929.60 = a loss of A$132.80.