The risk-reward ratio measures the potential profit for every dollar risked. It is the ratio between the value at risk and the profit target. If I was to tell you that you can lose more often than you win and still make money trading the markets, would you believe me or think I am crazy?
The problem with new traders is that when they first start out, they want to be RIGHT when it comes time to trading.
After all, this is a pattern that has been ingrained to us as kids – since we started to go to school, we needed to get passing marks in order to advance into the next grade.
When we started to get out in the workforce, we had to say the right things in order to get our dream jobs.
Once we got the dream job, we had to do the right thing to stay employed.
This is why there is an inherent human need to be right for survival and to get by – however – in trading, being right carries no currency and it has ZERO value.
What you need to do instead is to be profitable and the way to do that is by ditching the need to be right and implementing reward to risk management.
What is the Reward to Risk Ratio?
The reward to risk ratio is used by traders to compare the expected returns of a trade relative to the amount of risk required to earn those returns.
The relationship between these two numbers can tell a trader if the potential reward outweighs the potential risks on a certain trade which can help qualify or disqualify the trade idea.
How to Calculate the Reward to Risk Ratio?
In order to calculate the reward to risk ratio for a trade, a trader will require three distinct variables:
- The Entry Price
- The Stop-Loss level (Risk)
- The Take-Profit level (Return)
Defining The Variables
The entry price is where the trader plans on taking the trade – more often than not – traders use to limit or stop orders to plan their trade and the entry price is the first variable required for this calculation.
The risk is defined as the total amount that can be lost on the trade and is the difference between the entry price and the stop-loss price level.
The reward is defined as the total amount of potential profit to be made on the trade and is the difference between the profit target and the entry price.
The Reward to Risk Ratio Formula
Reward/Risk Ratio = (Distance between Profit Target and Entry Price) divided by (Distance between Entry Point – Stop Loss)
What does the Reward/Risk Ratio tell You?
Now that you are more familiar with the calculation of the reward/risk ratio, let’s take a look at some example scenarios using S&P 500 futures contracts (1 point = 4 ticks).
A trader wants to buy 1 S&P 500 mini contract at $3200.00 with a stop loss at $3198.50 (1.5 points or 6 ticks) and a take profit at $3203.75 (3.75 points or 15 ticks), what is the R/R ratio?
R/R Ratio: (3203.75 – 3200) / (3200-3198.50) = (3.75 points reward/1.5 points risk) = 2.5
A trader wants to sell 1 S&P 500 mini contract at $3200.00 with a stop loss at $3202.00 (2 points or 8 ticks) and a take profit at $3198.00 (2 points or 8 ticks), what is the R/R ratio?
R/R Ratio: (3200-3198) / (3202-3200) = (2 points reward/2 points risk) = 1
If we examine both scenarios, we can see that the trade-in scenario A has a higher reward to risk ratio then the trade-in scenario B – but what does this mean?
In scenario A, for every $1 that the trader risks on a trade, they are expecting a return of $2.5, whereas in scenario B, for every $1 that the trader risks on a trade, they are expecting a return of $1.
Does the Reward to Risk Ratio Quantify a Trading Edge?
There are some that argue that the reward-risk ratio is useless and when used in isolation we would agree!
However, when you combine the R/R ratio with other trading metrics – namely the “win rate” – we can start to develop a better understanding of the potential profitability of a trading strategy!
Having an edge in the markets simply means that you have a positive profit expectancy.
At the end of the day, by default, we have a 50/50 chance of success when taking a trade so when we know the reward/risk ratio of a strategy, then we can also calculate the win rate required in order to break even with that strategy.
By combining the R/R ratio with your winning rate, you will be able to quantify your edge in the markets.
The formula to calculate the win rate is: 1/(1+Reward/Risk Ratio)
So using our examples from above, the trader in scenario A with an R/R ratio of 2.5 would require a win rate of around 28% (1/(1+2.5)) in order to break even with this strategy.
This means that Trader A can lose a majority of the trades they take and still end up in profit!
Whereas the trader in scenario B with an R/R ratio of 1 would require a win rate of around 50% (1/(1+1)) in order to break even with this strategy.
This means that Trader B will have to be right a majority of time in order to end up with profit!
Finding the Best Reward to Risk Ratio For Your Trading!
Not all trading strategies are created equally and what works for one person might not work for the next!
When it comes to choosing the right reward-to-risk ratio to implement for your strategy, it is important to understand your numbers and your own personality traits.
A general rule of thumb is that the higher the reward to risk ratio, the lower the win rate percentage a trader can expect and vice versa!
Let’s say that you have a win rate of 40% with a strategy that implements a reward to risk ratio of 3:1 (meaning for every $1 of risk, you stand to earn $3).
If you wanted to increase the win rate on this strategy, you would have to reduce the reward to risk ratio to something like 2:1. By doing this, the probability of a winning trade increases because the distance the market has to move in your direction has been reduced.
If you have a personality type that has no issues with losing more trades than you win, you would be able to increase the reward to risk ratio to something like 4:1 on this strategy and in doing so, you would effectively decrease the win rate while simultaneously increasing the average amount of profit you take in when you do win.
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The information contained in this post is solely for educational purposes and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable for your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.