What is risk vs reward ratio?
If you have spent some time trading before or if you have studied other traders then you will likely have come across the term “risk reward ratio”. This is a crucial aspect of trading that we must understand if we are to become profitable in the long run.
The risk reward ratio is simply the amount of capital that we are risking for the potential gain that we are targeting.
How to calculate R-R-R
Whenever we want to enter a trade we should calculate our risk/reward ratio first. All we need to have is our entry price, stop loss price, and our target price.
For the sake of simplicity, let’s use round numbers to explain how this works.
Let’s say we are going long on a currency with an entry price of $100.
First we need to ask, how much would we lose if we lost our trade:
Next, how much would we profit if our trade won? From this we can work out what our risk/reward ratio is 60/20 = 3:1. In this example our reward is three times the size of the risk.
Now let’s use an example using pips. Let’s say we are entering a scalping position trying to make a 10 pip gain and we set our stop loss at five pips.
In this case we stand to lose five pips if our trade loses and we win 10 pips if our trade wins.
10/5 = 2:1
In this example, our risk to reward ratio for the scalp would be 2:1.
Easy enough, right? But what does this mean and how can it help with our trading?
Why is risk vs reward important?
When we know what risk reward ratio we will be trading with we can easily find out what winning percentage we need in order to be profitable traders. This is very handy to know as you can always stop and take stock of how you are performing and just how far away you are from becoming a winning trader.
Let’s take a look at what we would need to do to break even if we trade at some different risk to reward ratio.
The problem with too high a RRR
As you can see, the required winning rate drastically reduces as we increase our risk to reward ratio.
Sometimes when newbie traders see this, their eyes light up with the sight of the low winning rates, and they think that it would be easy to attain these levels and instantly become a winning trader. While there is some logic to be found in this, there are a few drawbacks that we need to consider.
Firstly, the higher we go with the RRR, the longer our trades will last, and the more exposure we have to the market. As we have mentioned many times throughout this unit, trading is mostly a mental game.
The longer we expose ourselves to the market, and the longer we have open positions, then the more chance there is that our emotions will get the better of us and interfere without trading.
Secondly, if we have a long RRR, we will get stopped out more often than not, and we will have to overcome dealing with many consecutive losses, which can be a tough burden for even the most seasoned of traders.
Lastly, traders will often cut their trades short when they are in these types of trades and will take their profit early. While at first, this may seem like a bad idea, but what they are actually doing is dooming themselves to being massively unprofitable.
If they cut their winning trades short every time, they will not be reaching that four, five, or six times target that they were aiming for.
That means that they will not be making up for all of those small losses that they have racked up, and they will often never reach the high targets that they set.
Note: It is entirely possible to be a winning trader using high risk to reward ratios, but it is much more difficult. For newbie traders, it is recommended to stick to a lower ratio while starting out until you can find your sweet spot.
What RRR should I use?
It all depends on what type of trader you want to be, however, most traders seem to agree that somewhere around the 3:1 RRR is somewhat of a sweet spot.
When selecting a 3:1 RRR, you will still hit a large portion of your trades without getting continually stopped out and left feeling demoralised.
A 25% win rate using this RRR is definitely achievable using the strategies that we have already brought you in this course, you just need to stick to your trading plan and ensure you trade with discipline every time.
One of the main dangers comes with cutting your winning trades short, so be aware of moving your stop loss to a breakeven position when you don’t need to.
Constantly manage your trade for signs that your initial theory has now become invalid. If it has, it is perfectly fine to exit.
Final word on RRR’s
At the end of the day, the risk to reward ratios are not set in stone. You should chop and change them to fit in with your trading plan and set your targets based upon key levels that you identify in the market.
If you want to set a trade up with a RRR of 3:1 but you see that there is a significant resistance level where 2:1 RRR would be then it would certainly make sense to adjust your trade to avoid that.
The risk to reward ratios should be used as a tool to guide us with our targets and help us trade, not to hinder us from applying solid trading fundamentals to each trade.