- Summary:
- Before entering a new trade it is important to learn how to calculate Risk Reward Ratio, to optimize the probability of your overall trading success.
The ratio between a particular trade’s potential profit and its potential loss is known as the risk reward ratio of a trade. For instance, in a trade setup with a 50-pips stop-loss and a 50-pips-take-profits, the risk to reward is said to be 1. Alternatively, if the trade setup has 50 pips stop loss and a 100 pips take-profit level, the reward-risk ratio is said to be 2.
Thus, the reward-risk ratio depends on the potential profit of a trade as relative to its potential loss. The concept is further explained in the chart below.
The chart shows a hypotechical trade in gold, with an entry at the time the price took out the upper end of a rectangle pattern, and how the price rose to more than three times the risk.
The risk is the difference between the entry and stop loss price, and in this example we used a rectangle pattern. When the market reaches the R/R 3:1, then this means that the market has produced a reward three times the risk.
Example of Risk Reward Ratio Calculation
What is a good risk-reward ratio?
A high R/R ratio means that we don’t need to be right all the time to make money trading. For instance, if we take 100 trades, all having a Risk Reward Ratio of 1, with a winning rate of 50%, there will be 50 winners and 50 losers. In this example, you would end up around breakeven as the loss per trade equals the profit per trade.
If we take another example where the trades have an R/R ratio of 2, it means that the average winning trade is two times its average loss. In this case, you will end profitable even with a 50% winning rate, as the winning trades would be more than enough to cover for the losing trades.
Some research from major brokers indicates that profitable traders tend to incorporate a risk reward ratio of higher than 1.
According to that research, traders who used a R/R ratio more than 1 had three times more chances of attaining a profit, as compared to traders using an R/R of less than 1. 53 % of the traders were profitable in the first group while only 17% of profitable traders belonged to the second group.
It should be remembered that stop-loss orders play a key role when setting up the reward-to-risk ratio. The research suggests that traders should maintain an R/R ratio of at least one in all the trades. For trade setups that do not return the desired reward to risk level, you can simply dismiss it.
Risk of enforcing an arbitrarily high Reward-Risk Ratio
Just enforcing a very large risk-reward ratio is not good as my own experience shows that it appears to be an inverse relationship between the profitability ratio and risk-reward ratio, this means that the higher the risk-reward ratio the lower the profitability ratio. This makes sense as to have a high-risk reward ratio means that your stop loss order will be much closer to your entry price than your take profit price, and that means that normal volatility can easier get you stopped out.
As an example, if your entry is 1.30, take profit is at 1.31, and your stop loss is at 1.2970, then the price is just 30 pips away from your stop loss level, and 100 pips away from your take profit. The risk-reward ratio will be a good 3.33, but the likelihood that the price will reach your stop level before reaching your take profit is higher.
In situations where volatility is higher such as day trading or scalping it is normal to see traders have inverse risk-reward ratios, on the other hand, they tend to be right more than 50% of the time. In the case of position and swing traders that usually hold positions for a few days, they tend to easier acquire higher risk-reward ratios.Don’t miss a beat! Follow us on Twitter.
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