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Risk-Reward Ratio: A Guide

Posted by BluFX on 11-Dec-2019 10:45:23

RISK REWARD

Your risk-reward ratio is one of the first elements you should incorporate into your trading plan. Put simply, a risk-reward ratio measures the difference between the profit potential of a trade relative to its loss potential.

There’s one important thing to remember about risk-reward ratio: it’s the most useful when it’s used alongside other trading metrics - such as win rate.

Here’s your guide to what you need to know…

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Risk-Reward Ratio

What is risk-reward ratio?

Risk-reward ratio measures the difference between the potential profit and potential loss of a trade. Losses are a crucial part of trading, and so a risk-reward ratio is designed to help you manage these losses.

Put simply, if a trade a 100 pips stop-loss and a 100 pips profit target, the risk to reward of that trade would be 1.

In a more detailed example: if you buy a stock at $15.60, places a stop loss at $15.50 and a profit target at $15.85, then the risk on the trade is $0.10 ($15.60 - $15.50) and the profit potential is $0.25 ($15.85 - $15.60).

The risk is then compared to the profit to create the ratio: risk/reward = $0.10 / $0.25 = 0.4. If the ratio is greater than 1.0, the risk is greater than the profit potential on the trade. If the ratio is less than 1.0, the profit potential is greater than the risk.


What are some examples of risk-reward ratios?

If you have a risk-reward of 1:3, it means you are risking $1 in order to potentially make $3. With a risk-reward ratio of 1:4, you are risking $1 in order to potentially make $4 - and so on.


How should I use risk-reward ratio while trading?

Many traders use risk-reward ratios - alongside other trading metrics - to compare the expected returns of a trade with the amount of risk they must undertake to earn these returns.

It’s up to you how you use risk-reward when trading, but ultimately it’s designed to help you manage your risk. Traders set a risk-reward ratio in order to manage their capital and assess how much they are willing to risk per trade - and this will be unique to every trader.

When setting your own risk-reward ratio, it’s crucial to consider your win rate.


What is win rate?

A risk-reward ratio is designed to help you manage your losses and your capital - so essential to this is calculating the minimum win rate required to be profitable.

So: how do you calculate your win rate? Trades won/total trades made = win rate.

For example, if you make five trades a day, and win three, your daily win rate is 3/5=0.6, or 60%.

The win-loss ratio is your wins divided by your losses. Assume you won 60 of your 100 trades, and lost 40. The win-loss ratio is 60/40 = 1.5, which means you are winning 50% of the time more than you are losing. A win-loss ratio above 1.0 (or a win rate above 50%) is favourable.


What should my risk-reward ratio be?

It’s a personal choice that will depend on your available capital and your win rate - and how much you are willing to risk - but it’s generally recommended that you risk no more than 1-2% of your capital per trade. Risking any more than 4 or 5% of your capital per trade is considered high risk, so it’s best avoided if possible.

Generally speaking, a good risk reward ratio is usually anything greater than 1 in 3 - but as we have explored above, this is also dependent on your win rate.


What should I be aware of when setting a risk-reward ratio?

It’s crucial to strike a balance between your risk-reward ratio and your win rate. In order to make consistent profit, a high win rate may mean nothing if your risk-reward is very high - and equally a great risk-reward ratio may mean nothing if your win rate is very low. It’s all about striking a good balance.

Something to remember is that you don’t need a very high win rate or a low risk-reward ratio in order to make a profit.

As with any aspect of your trading plan, you may need to undertake some trial and error to find a risk-reward ratio that works for you.

  • What a higher win rate means: your risk-reward ratio can be higher. You can still be profitable with a 60% win rate and a risk-reward of 1.0 - but you’ll be more profitable with a 60% rate and a risk-reward below 1.0.
  • What a lower win rate means: if your win rate is 50% or below, your wins will need to be larger than your losses in order to be profitable. If your risk-reward ratio is below 0.6, you can still be profitable even if your win rate is around 40%. It’s generally recommended that you aim for a risk-reward ratio around 0.65 if your win rate is below 50%. Put simply: the more you lose, the bigger your winners must be when you do win.

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Tags: Trading Tips, Risk and loss

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