A risk:reward ratio can play an essential part of your trading strategy and ensure that you're not risking too much of your capital. Learn how to use ratios effectively .
In this lesson you’ll learn:
A risk:reward ratio is utilised by many traders to compare the expected returns of a trade to the amount of risk undertaken to realise the profit. To calculate the risk:reward ratio, you divide the amount you stand to lose if the price moves in an unexpected direction (the risk) by the amount of profit you expect to have made when you close your position (the reward.)
Some of the most popular reward:risk ratios are 2:1, 3:1 and 4:1 and these will change depending on the strategy of the trade. Of course there are other aspects which may affect the risk of a trade, such as money management and price volatility but having a solid reward:risk ratio can play a strong role in helping you to manage your trades successfully.
An example of a risk:reward ratio
Let’s say that you decide to go long on ABC shares. You ‘buy’ 100 lots, equivalent to 100 shares, which are priced at £20 for a total position value of £2,000 - on the basis that you believe the share price will reach £30. You set your stop loss at £15 to ensure that your losses do not exceed £500.
In this case then, you’re willing to risk £5 per share to make an expected return of £10 per share after closing your position. Since you’ve risked half the amount of your profit target, your reward:risk ratio is 2:1. If your profit target is £15 per share, your reward:risk ratio would be 3:1, and so on. Therefore, it’s possible that one profitable trade will cover two, three (or more) losing trades.
It’s important to remember however, that while risk:reward ratios helps to manage your profitability, it doesn’t give you any indication of probability.
The importance of a risk:reward ratio
Most traders aim to not have a reward:risk ratio of less than 1:1 as otherwise their potential losses would be disproportionately higher than any likely profit i.e. a high-risk trade. A positive reward:risk ratio such as 2:1 would dictate that your potential profit is larger than any potential loss, meaning that even if you suffer a losing trade, you only need one winning trade to make you a net profit.
Below we have included a table below to highlight different reward:risk ratios and their impact on your total profits and losses. The table below assumes 1 is equal to £100 and you have a win rate of 50% across 10 trades.
You can see clearly from the table below the potential benefits of having a positive reward:risk ratio and how this can impact your net profitability.
Probability is key:
We mentioned probability briefly above, but let’s take a more in-depth look.
Let’s say out of your last 100 trades, 60 were profitable. That gives you - or your trading system - a probability of 60%. Probability depends on your trading system as well as your emotional ability to stick to that system.
What’s more, the main objective of every analysis made ahead of entering the market is to maximize the chance of entering a high-probability trade. If you look for a specific technical pattern, you are trying to maximize a probability. Why? Because as it appears it should be followed by a specific move of the price. By searching for a pattern you are potentially increasing your chances of finding a higher probability trade.
Choose the one for you:
Each trader has their own trading strategy and risk-reward ratio that is the most suitable for them. One of the challenges of trading is finding a system that works for you and one that ‘fits’ your mindframe.
If we think about risk tolerance on a spectrum, where do you think you would be? Are you risk-averse, cautious and calculated? Or are you open to taking more risk and enjoy the adrenaline?
The most important thing is to choose a system of risk and reward that is manageable for you and that potentially increases the chances of your trading being as successful as possible. There’s no specific rule - you just have to find a perfect one that suits your strategy.