Risk/reward ratio (or RRR) is the amount of pips you are willing to risk on a trade divided by the number of pips you are targeting.

For example, let’s say we go short on EURUSD at 1.3080, with a 20 pip stop loss and a 60 pip take profit level. Then our RRR is 20:60 = 1:3. Using this risk/reward ratio, you only need to win 3 trades out of 10 to make a profit. Why? Well, let’s do a little math:

7 losers of 20 pips each = 7 * 20 = -140 pips loss

3 winners of 60 pips each = 3 * 60 = 240 pips gain

result = 240 – 140 = 100 pips

Of course, it is crucial that you first come up with a good trading plan and possibly write down your trading rules somewhere, so you always stick with them. Then you need to monitor your performance. The broker usually does this for you though. I’ll show you how InterbankFX displays my stats:

My trading performance since i started

This is my trading performance spanning 1.5 months of trading (25 October – 13 December 2008).

Using this chart, we can compute our winning rate. The formula is: ( (Total winning trades + Total Breakeven trades) * 100) / Total trades = 23100 / 364 = 63.5% with aproximation.

What else do you see from this chart? Well, first, you can see that the average amount of pips won is almost 4 times less than the average amount of pips lost. That means a disastruous risk/reward ratio. The 95.53$ loss also shows us that I didn’t use a sound risk/reward ratio. So, even though I win 64% of the time, I still lose money. That’s because I’m stupid. But I found out that I’m stupid, so maybe I’ll be smarter from now on

And we see yet another interesting thing. Total trades is 364. So 364 trades in 36 trading days. That means about 10 trades in one day. So I was also overtrading a lot. I should make at most 10 trades per week, not per day.

From this chart we can also see that I must have been overleveraging. How else can you lose 95$ out of a 250$ account? I was a beginner, so I should have only traded 0.01 mini-lots (100$). 95$ means 9500 pips in that case. But I didn’t lose so much. The lost pip amount is much lower than that, but the problem is that I even traded 5 mini-lots when I started. I lost 50$ in a few minutes once. Now I’m over this and I only trade 0.01 mini-lots until I become profitable. After I will have steady and consistent profits, I will trade 0.02 mini-lots. Then 0.04, then 0.08. But until then, I am learning, so why not preserve my capital while I do this? If you are a noob, please listen to me and do not make the same mistakes I made. Be smart, keep it simple, stick to the rules, don’t be greedy, and you’ll get there much faster than me.

I’ll be talking about stop loss and take profit levels soon and let you know what I have learned about them.