Stop Distance and Risk-to-Reward

Setting the stop distance

The stop goes where the trade idea is invalid: beyond the swing low for a long, beyond the level whose break would change your view. Then check it against volatility: a stop closer than the average true range of the timeframe is inside the noise and will be hit by chance. If the sensible stop is too far for the risk budget, the answer is a smaller position, never a closer stop.

The ratio

Risk-to-reward is target distance divided by stop distance. 30-pip stop, 60-pip target: 1:2. 30-pip stop, 30-pip target: 1:1. A ratio below 1:1 means you are risking more than you stand to make, which requires a high win rate to be worthwhile. The ratio is set when the trade is planned; a trade whose target keeps moving does not have one.

Break-even win rate

Break-even win rate equals one divided by one plus the reward-to-risk multiple. At 1:2 you need to win one trade in three to break even before costs, and anything better is profit. That is why trend-following strategies with 40 percent win rates can be strongly profitable, and why a scalper at 1:0.5 needs to be right two times in three just to stand still.

The trade-off

Wider targets are hit less often, so higher ratios usually come with lower win rates. The combination that works is a matter of strategy and temperament; there is no best ratio. What is fixed is that the ratio and the win rate must together produce a positive expectancy, which Course 8 measures.

Key takeaways

• Stop where the idea fails and beyond the noise; size to it.
• Risk-to-reward is target distance over stop distance, set in advance.
• Break-even win rate is one over one plus the reward multiple.
• Higher ratios trade win rate for payoff; the pair must give a positive expectancy.