Drawdown and Risk/Reward Ratio: The Danger of a Losing Streak
Even if you feel very confident about your trading strategy, using one that results in a gain, say, 65% of the time, sooner or later you will incur in a losing streak. It is important to keep the chances of a serious drawdown occurrence, when a losing streak happens, to a minimum by using a proper risk/reward ratio when you place your next trade.
Drawdown and Maximum Drawdown in Forex
Let's say, you lose a series of trades, which bring your equity from an initial $10,000 to just $6,666.66. You lost 33% of your account, but how much do you have to get back to where you started from, relative to your current account?
If you answered 33%, you are wrong. The actual percentage you have to earn back is 50%. In fact:
Let's see what happens if you continuously lose 20% and win back 20% of your account.
Do you see where it is going? Due to drawdown, alternately winning and losing 20% (or any other percentage) of your account is not enough to stay even at the end of the day. This holds true even if you started with a winning trade — it would just take a bit longer.
As we hope you realized, recovering from a consistent loss in Forex, like in any other form of investment, gets increasingly harder. This is why you need to try avoiding serious drawdowns by using an adequate risk/reward ratio.
Risk/Reward Ratio in Forex
A risk/reward ratio is, like the term suggests, the ratio between the expected maximum loss and the maximum gain. The great thing about Forex trading is that you can calculate the R/R of your prospective trades beforehand (using stop-loss and take-profit values) and decide whether to take the trade based on its R/R ratio.
For instance, if your strategy tells you to place the stop-loss at 20 pips and your take-profit at 40 pips, your R/R ratio is 2:1. Please note that some traders use the "reward/risk" ratio term instead, but that does not really change anything. The conventional term is "risk-to-reward" ratio, not "reward-to-risk."
What is a good R/R ratio? If you understood what we just said about drawdown, you know that a ratio of 1 is not going to work in the long term! In fact, drawdown is precisely the reason why you should always enter trades with a stop-loss tighter than your take profit.
As an example, if you enter the trades solely with a risk/reward ratio of 2:1 and your strategy lets you win 50% of your trades, here is what your account will look like after alternately winning 20% and losing 10% of your account:
Of course, entering in trades at random will not give you a 50% chance of winning, because the profit target is more distant than the stop-loss (and do not forget you have to factor in the spread, too). However, with the help of tools from technical analysis and a bit of experience, coming up with a strategy to earn this figure is certainly feasible.
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