It is worth noting that a favorable risk/reward ratio can change your trading. Most traders spend all their time trying to find a profitable trading strategy. As a result, they often forget about the importance of the risk/reward ratio. As a result, they only aim for the number of profitable trades. But this is a huge mistake. It is much easier to maintain an optimal risk/reward ratio than to close 60% of profitable trades.
When you trade in any financial market, you are primarily involved in certain risks in order to get rewarded. In fact, calculating the risk/reward ratio determines the amount of money you are willing to risk in order to get a certain profit from a particular trade.
If you are a novice trader, there are chances that you have a very vague idea of what it means to accurately calculate risk. Even a large number of experienced traders do not take the time to correctly calculate the risk/reward ratio of each trade before placing an order with their broker.
In this article, I will explore the idea of the risk/reward ratio. As a result, I will give you a better understanding of the entire concept, thus showing you the importance of this element for your management strategy.
The importance of the risk/reward ratio
If you are a novice trader, you may have some experience in making a profit. However, just a single bad trade could destroy all your profits. This phenomenon is not unusual among inexperienced traders, because they do not understand the importance of risk management.
The key to success as a trader is to find the right balance between the risk per trade and the desired profit you are aiming for. In addition, this balance should be realistic and match your trading strategy.
For example, you decide to set a profit target three times higher than the initial stop loss, with a risk/reward ratio of 1:3. But what if your strategy is not able to provide such a risk/reward ratio in the long run? In this case, you will end up losing money.
On the other hand, if your trading strategy is capable of making trades with a risk-to-profit ratio of 1:5, but you usually close the trade when your profit reaches a level of only two times higher than the stop loss, you always leave money in the market.
Therefore, you should spend a lot of time testing your strategy and trying to determine the realistic average profit that your trading strategy brings in each trade relative to your stop loss.
What is the R multiplier?
As George Soros once said:
It does not matter if you are right or wrong. What really matters is how much you earn when you are right, and how much you lose when you are wrong in your predictions.
These words are the essence of the risk/reward ratio. In other words, before opening each trade, you first need to make sure that this trading is worth the risk. For convenience, we will use the R multiplier.
The concept of R multipliers is extremely simple, but effective. "R" stands for risk. The number that is placed before R indicates the risk/reward ratio.
The amount of your risk is always equal to 1R. It does not matter if you risk 2% or 5% of your deposit. The risk is always taken as 1R.
If I use 2R on GBPUSD, it means that my potential profit is twice the potential loss. In other words, a trading setup with a stop loss of 50 points and a take profit of 100 points is 2R. If a 1R loss is $50 and I earn $100, then I get a 2R profit.
Some traders believe that the risk/reward ratio of 1:2 or 1:3 is difficult to achieve, and the number of profitable trades in this case will inevitably decrease.
It is partially true. If we take the 5R ratio, where the risk is 100 points and the potential profit is 500, this trading setup has little chance of success, since such movements rarely occur in the market. On the other hand, if the risk/reward ratio is equal to 1R, the price is more likely to pass 100 points in the direction we have chosen.
Success in trading is not only a high percentage of profitable trades. It is also a good risk management. Trading robots can show a 90% return, but at the same time, they risk 50 points to earn 10 points of profit.
One of the reasons why many traders avoid risk/reward multiples is that it is often difficult to determine whether the price will reach the selected target or not. However, we can never know in advance what will happen in the market in the future. There are always too many variables that constantly affect the price movement. Therefore, the trader's job is to determine the most likely scenario.
What is the risk/reward ratio?
The risk/reward ratio measures your potential return for a given amount of risk.
For example, if your risk/reward ratio is 1:3, it means that you risk $1 to earn $3.
Do not be fooled by the risk/reward ratio. You can stick to a 1-to-2 ratio and keep losing money. On the other hand, you can use a risk/reward ratio of less than 1 to 1 and earn consistently.
There is a well-established stereotype among traders that the risk/reward ratio should be at least 1:2. But I strongly disagree with this. Why? The thing is these numbers do not mean anything themselves.
Let us say your risk/reward ratio is 1:2. In other words, you earn $2 in each trade if the trade is successful and lose $1 in all other cases. The percentage of your profitable trades is 20%. So, out of 10 trades, you have 8 losing trades and 2 profitable ones. As a result:
- The total loss = $1 * 8 = -$8.
- Total profit = $2 * 2 = $4.
- Net loss = -$4.
Now you understand that the risk/reward ratio itself is meaningless. Therefore, you should combine it with the percentage of profitable trades in order to understand whether you will earn in the long run.
How do I calculate the risk/reward ratio?
The formula for calculating the risk/reward ratio is relatively simple. If you risk 50 points in trade and set a profit target of 100 points, your effective risk/reward ratio for the trade will be 1:2.
Also, in real trading, you need to take into account the spread charged by your broker in order to effectively analyze risks and rewards. If you do not pay attention to the spread, you will end up using the wrong risk/reward ratio for your trades.
For example, if you are a scalper who likes to risk a maximum of five points per trade and you want to get about ten points from each of your trades, and you think you are getting a risk-to-profit ratio of 1:2... You need to think again!
If your broker charges pips on EURUSD, then you are actually risking 7 pips to get 8 pips of profit, which means that your net risk/reward ratio is actually only 1:1.14, and not 1:2. The reason is that you didn't take into account transaction costs.
You do not need to be a math genius to realize that a much higher winning ratio will be required to compensate for such a huge difference in the risk/reward ratio due to spreads.
While the spread effect is most severe for scalpers and day traders, this effect usually becomes more blurred for swing traders and position traders who trade on higher timeframes.
Let us now look at the example of trading in the figure below. If we calculate the risk/reward ratio in a trade with a stop loss of 100 points and a profit target of 200 points, our calculation should lead to a completely different result. Let us assume again that the spread for GBPJPY is five points.
100 + 5 = risk of 105 pips, and 200-5 = reward of 195 pips = 1:1.85 risk ratio.
Impact of the percentage of profitable trades on the risk/reward ratio
In addition to understanding the overall risk/reward ratio in your trading strategy, you also need to figure out the impact of the profit ratio. If you already know the historical risk/reward ratio of your back-testing trading strategy, you can apply a simple formula to determine what profit ratio you need to maintain in order to remain profitable in the long run.
Required win ratio = 1 ÷ (1 + historical risk ratio for your trading strategy)
For example, if you know that your trading strategy has an expected risk/reward ratio of 1:1 as a result of testing on history, then you can get the following results:
1 ÷ (1 + 1) = 0.5, which is 50%.
Thus, you need to maintain at least 50% of profitable trades to break even. With this trading strategy, if you keep 55% of your winnings, you should remain profitable in the long run. However, if your trading strategy has a win rate of just 50%, it can provide a 1:2 risk/reward ratio on a consistent basis.
If you already know your system's win rate from extensive history testing but haven't yet figured out what risk-reward ratio you will need to stay profitable in the long run, you can apply a different formula:
Required minimum risk/reward ratio = (1 ÷ historical gain of your trading strategy) - 1
For example, if you know that the historical percentage of profit in your trading strategy is 40%, then including it in the formula will give the following result:
(1 ÷ 0,4) – 1 = 1,5
So, to stay profitable in the long run with this trading strategy, you need to maintain a risk/reward ratio of at least 1:1.5.
How can one analyze the risk/reward ratio?
We can easily calculate the risk/reward ratio. Here are three simple steps:
- Find out the distance to the stop loss.
- Find out the distance to take profit
- Use the formula: distance to take profit/distance to stop loss.
For example, our stop loss is 100 points, and the target profit is 200 points. We get:
200 / 100 = 2.
Thus, the risk/reward ratio is 1:2. Do not forget that this ratio itself does not mean anything without a percentage of profitable trades.
How can one improve the risk/reward ratio in a positive way?
How can one increase the chances of making a profit when using multiples of R greater than 1?
- Define key levels.
- Trade according to the trend.
- Use graphical formations.
- Calculate your exit from the position in advance
Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial advice. Trading and investing in financial markets involve risks, and individuals should seek professional advice or conduct thorough research before making any investment decisions.