The key to trading success is having a solid understanding of the risk your capital is exposed to and how that risk relates to potential profits. That is the reason that we are constantly breaking down how the average annual profit of a strategy relates to its maximum drawdown. In order to understand a strategy, we have to understand how each of its trades work from a risk/reward perspective.
Nial Fuller from Learn to Trade the Market is a strong advocate of risk/reward analysis. In a recent post, he said:
It is critical to understand that most traders who are successful over the long-term are not winning more than about 50% of their trades, but it doesn’t matter as long as they are harnessing the power of risk / reward.
In that post, Nial breaks down the tool he uses to analyze the risk/reward for each of his trades. He provides a simple walkthrough for how to build his risk/reward tool in MetaTrader. The tool is constructed by adjusting the settings of the Fibonacci tool that is already built into the program.
How To Construct The Risk/Reward Tool
In his post, Nial explains that his risk/reward tool is basically a modification of the built in Fibonacci tool. The first step to construct the risk/reward too is to open the Fibonacci tool, then right click on it and go into Fibonacci properties.
The next step is to set a stop-loss level. The distance between the entry price and the stop will define the 1R distance that all of the reward projections will be based on.
After the 1R distance is determined, Nial’s next step is to delete all of the other levels from the fibonacci tool except for the levels that mark the entry and stop prices. Then, the final step is to add profit targets as levels that are mulitples of that 1R distance.
After completing this simple tweak on the fibonacci tool, you will have an overlay that provides you with a visual representation of your current trade in relation to your strategy’s profit and loss targets. This visualization can provide interesting insight into how likely a given trade is to hit whatever reward level your system is anticipating.
Advantages of Using a Risk/Reward Tool
Nial also covers the fact that there are many positive uses for a risk/reward tool like the one he describes.
The biggest advantage is the ability to quickly and visually identify profit targets. In theory, this should make planning trades much easier. The tool will make this process much faster, which will allow a trader to process trades quicker.
The tool also allows the trader to experiment with how adjusting the stop level will alter the profit target levels. It can also be used as a method of filtering out good and bad trades, or as an early exit signal if a trade fails to perform after a certain period of time.