Understanding the risk/reward ratio and incorporating it into your futures trading tactics is essential if you want to succeed as a futures trader. Learning to use the risk/reward ratio can help you minimize your risks and maximize your trading profits.
What is the risk/reward ratio? The concept is fairly simple, though the execution is more complex. For each trade you compare the amount of risk to the potential amount of reward. In other words, what is the downside risk compared to the upside profit potential?
If the risk outweighs the potential profit, DON’T make the trade.
If the potential profit outweighs the risk, DO make the trade.
When futures traders are at work, they are constantly evaluating each tick of the market in terms of the risk/reward ratio. They are looking for trades that will give them the least risk while gaining the most profit. The risk/reward ratio can help a trader determine which of several possible trading actions will potentially be most profitable. The concept is fairly simple, so how hard can it be to execute? Much harder than you think!
Using the risk/reward ratio. The problem many futures traders have in utilizing the risk/reward ratio is that market movement and the actual risk or reward value of any trade can never be objectively or precisely pre-determined. No one can know what will actually happen in the future, whether that future be a minute from now, an hour from now, tomorrow or next week. A futures trader is limited to technical analysis and common sense. Based on previous market action and previous trading experience, he can predict what might happen, but the actuality must await the event.
Savvy futures traders watch technical support and resistance levels to help determine risk/reward ratios before entering a trading position. It is human nature to follow the pack, to buy on an upturn and sell on a downturn. Savvy traders have learned to watch the small changes in support and resistance levels to time their trades to minimize risk and maximize profit. Selling into a rally has greater potential profit than buying with the pack. If you sell into strength, you are guaranteed plenty of buyers eager to purchase what you’re selling. If you buy into a rally, the rally will eventually peter out and you’ll be caught chasing the trend downward, losing money at every tick. Smart traders have already taken their position before the market starts to run upwards. Even if you do not sell at the peak of the run, you will have made a profit. Novice traders often get greedy when they are in this position. It is possible to wait too long to sell and get caught when the market corrects and heads down again. Remember: You’ll never go broke making a profit, even a small one. Small profits add up.
Likewise, the time to buy is often when the market takes a small dip. Buy on a pullback to give yourself a better entry point and higher profit when the stock rallies again. Though it goes against the norm, often your best risk/reward ratio can be realized by doing the opposite of what the pack is doing.
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