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Monday December 18, 2006 - 12:32:34 GMT
FX Thoughts for the Day -

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FX Thoughts for the day - Evening - 18-Dec-2006...1202 GMT

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Our comments on Dollar-Swiss, Sterling Pound and Australian Dollar are given below

TRADER'S ANGST (Or Risk/ Reward Redux)
It is the end of another Annus Horriblis. Better to clean some cobwebs of the mind than to rave and rant.

Of TPs and SLs
Most Traders will agree that 60% of the times they miss their Take Profit (Limit) orders by 2-5 pips, or miss a dream Entry Order by 2-5 pips. And frustratingly, 60% of the times their Stop Loss Order gets triggered just 2-5 pips inside the top/ bottom of the market. Is this not true?

Today we asked ourselves, "Why is this so?" Is a strange diabolical phenomenon perpetually working against the Tribe of Traders? No. Looking at things dispassionately, it is clear that we tend to place our TP (Limit) at levels which are 60% more difficult to reach, while our SLs are 60% easier to reach.

The phenomenon that is working against us is our own Greed (which makes us place the TP that extra 5 pips wider) and our Fear (which makes place the SL that extra 5 pips narrower). All that might be needed might be to make the TP narrower by 10 pips and the SL wider by 10 pips.

Risk/ Reward Ratio
But wouldn't keeping a narrower TP and a wider SL make the Risk/ Reward Ratio go out of whack?

For the uninitiated, the Risk/ Reward Ratio is one of the oldest tools of Risk Management/ Loss Containment. It says that, as a rule, for any given trade, the ratio should be less than 1, or in other words, the Risk should be less than the Reward. Obviously. Otherwise why would one trade? Or, at the least, the Ratio should be 1 (Risk = Reward). It should never be greater than 1.

How does one get an RR <= 1? Simply by choosing Profit and Loss targets appropriately. For instance, a Traders may keep her Profit target at 50 pips and the Loss target also at 50 pips, to arrive at an RR of 1. Another, more conservative Trader may place a TP 75 pips away from Entry and keep the SL 50 pips away, thereby ensuring that the RR is less than 1 (50/75).

And, so do both of them reassure themselves that they are responsible and disciplined Traders. The RR Ratio is, in fact, a good tool and does prevent a lot of loss. BUT, as we've seen before, our greed/ fear ratio (another word for conservatism) makes us lose money 60% of the times.

Therefore the need for narrower SLs and wider TPs. But, coming back to the question, wouldn't keeping a narrower TP and a wider SL make the Risk/ Reward Ratio go out of whack? Suppose a Trader who usually works for a 50 pip profit and a 50 pip loss (RR = 1), now works for a 40 pip profit and a 60 pip loss, her new RR would be 60/40, greater than 1. How can that be acceptable?

Risk/ Reward Ratio Redux
All the RR calculations/ scenarios above are sans any Probability consideration. Or, at best, the implicit assumption is that the chances of both Profit and Loss are equal.

BUT, suppose placing a 10 pip narrower TP increases the chances of it getting executed, and a 10 pip wider SL reduces the chances of it getting triggered. Would that not be more desirable than equidistant TP/SL combinations or wide TP/ narrow SL combinations?

Thus, we now propose a fresh look at the Risk Reward Ratio....welcome the RR with Probability.


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