The Complete Guide to Risk Reward Ratio
The risk-reward ratio is noted as conducting measures concerning the reward level that you could potentially achieve when you complete a trade-in correlation to each dollar that you are willing to put up to risk. Take into consideration, for example, that if the risk-reward ratio is shown to be 1:3, this indicates that you are willing to put up one dollar to risk to gain three dollars in reward. Or if the risk-reward ratio is set forth as being 1:5, this denotes that you are willing to put forth one dollar up to risk to make a profit of five dollars.
The simple risk-reward definition we gave in our article Risk-Return Ratio – Risk Reward Ratio Explained:
The risk-reward ratio or risk-return ratio in trading represents the expected return and risk of a given trade or trades based on entry position and close position. A good risk-reward ratio tends to be less than 1; that is, the return (reward) is greater than the risk.
How to calculate the risk-reward ratio in forex?
To calculate the risk-reward ratio in forex, you need to divide the difference between the entry point price level and the stop-loss price level (risk) by the difference between the profit target and the entry point price level (reward). If the risk is greater than the reward (for example, 4:1) ratio is greater than 1, if the reward is greater than the risk (for example, 1:3), the ratio is less than 1.
Risk-reward ratio formula:
Risk-reward ratio = absolute value (Price entry value – stop loss value) / absolute value (Price entry value – target price value)
For example, based on this risk-reward formula, if we buy EURUSD and the entry price is 1.3 and stop loss is 1.2, and the target is 1.5, then:
(Entry price – stop-loss) = 100 pips (because from 1.3 till 1.2 there are 100 pips.)
(Entry price – target price) = 200 pips (because from 1.3 till 1.5, there are 200 pips.)
Risk reward ratio = 100/200= 1/2. Risk is 1 and reward 2, 1:2.
This is the best way how to calculate the risk-reward ratio in trading.
Risk reward ratio myth
I listen to all the time expressions – High-risk, high reward!
What is the relationship between risk and reward in investing, anyway?
The risk-return spectrum says that the risk-reward is the relationship between the amount of return gained on an investment and the amount of risk undertaken in that investment. This rule exists in all kinds of business, not just forex. Many traders are seeking low-risk trades where they try to risk a few pips and achieve high returns. The problem with this approach is the shallow winning rate. Psihologicly, this can be very stressful for traders.
Some people may be fooled by the risk-reward ratio and do not really know what it is or do not understand it well. If you are used to seeking trades with a risk-reward ratio of 1:2, you could likely continue to be the loser every time.
It is realized that when a trader seeks trades that tend to possess a risk-reward ratio that is lower than 1, the trader can potentially continue to be profitable in a consistent manner. Then this leads one to ask why this is so. This is because the risk-reward ratio is only one factor relating to the success that is achieved.
Now in terms of the lie that you have been given regarding the risk-reward ratio, you likely have been told that you must possess a risk-reward ratio set at 1:2. But that is not true at all. This is based on the premise that the risk-reward ratio does not carry much merit on its own. Take into consideration, for example, that the risk-reward ratio has been set at 1:2. This indicates that every trade that you are perceived as winning will yield you two dollars in profits. However, the fact is that your winning rate may only be twenty percent. This means that you may win only two trades when you have engaged in ten trades, resulting in losing the other remaining eight trades.
As a result, when the math is completed, this denotes that your total loss is eight dollars, and your total gain is four dollars. Thus, it is determined that your net loss is four dollars.
With this being the case, it is highly evident that it is imperative to comprehend that it is fruitless to apply the risk-reward ratio usage by itself as a metric. Rather, it is needful to combine the risk-reward ratio in conjunction with your winning rate to achieve a determination concerning if you will make profits in the long term–which is also referred to as your expectancy.
How to use the risk-reward ratio to be profitable
Risk reward ratio traders need to use the Winning ratio and Kelly ratio to create better position size and improve trading performance. If you use a 1:5 risk-reward ratio and your winning ratio is 3%, it is bad, even you have a great risk-reward ratio.
You need to know the secret to be profitable. Thus, you must divide the size of your winning by the size of your average loss and add one to it. Then you are to multiply this by your winning rate and then subtract one from this. This will determine your expectancy when you are conducting trades.
In a scenario where you conduct ten trades, six are counted as winning trades. On the other hand, four are counted as losing trades. Therefore, the result is that your winning percentage ratio is expressed as sixty percent or as six over ten. If the case is that six winning trades equated to grant you profits for three thousand dollars, it is commonly understood that your average win is regarded as being the amount of five hundred dollars. This is derived by dividing the number of profits of three thousand dollars by the number of winning trades, which were determined to be six wins.
Position size = Winrate – ( 1- Winrate / Risk reward Ratio)
In such a case that four of the trades were losses that equated to a total of one thousand and six hundred dollars, this means that your average loss is determined to be four hundred dollars. This was derived by dividing the total amount of money lost by the number of your losing trades.
Now it is time to apply this to the formula that was addressed previously. Thus, you will divide your winning trade average by the losing trade average, and you will then add one to this amount. Then you will multiply that by the percentage of your winning trades and minus 1 from the amount. Thus, the result is that your determined expectancy is considered to be 0.35, or it may be expressed as thirty-five percent. This is regarded as being a rather positive expectancy. This means that you will likely receive thirty-five cents for every dollar that you trade over the long term.
Thus, it is realized that the truth is that there really is no foundational minimum risk-reward ratio of 1:2. This is because one may possess a risk-reward ratio set at 1:0.5; yet, if the person possesses a high enough winning rate, then the trader will still gain profits over the long term.
With this being the case, the primary metric for consideration in terms of importance is not to be viewed as being the risk-reward ratio. Further, it is not to be viewed as being your winning rate. Rather, the most important factor to consider in terms of metrics at this point is your expectancy rate.
With this perspective in place, it is realized that it is not a good idea to engage in the placement of a stop loss at a rate that is considered to be arbitrary, such as one hundred pips up to three hundred pips, as this effort would not really result in making much sense. But rather, it is believed that it is best to engage in leaning against the factors of the markets that serve as barriers, as they engage in the prevention of the price point from aiming at landing on your stops.
Day Trading with Risk/Reward Ratios and Win Rate
So, what is a good risk-reward ratio? The good risk-reward ratio is the ratio that gives the best profit with a combined winning rate. So alone, without other rates, the risk-reward ratio is not an important parameter.
If your trading strategy offers you more trades, then it can be sensible to consider that you are losing profits. By the day’s end, winning trades may not always end up with profits,
The worth of losses and wins should be assessed by the day trades based on their risk-reward ratio, the ratio of win-loss, acceptable risks, and losses while creating ask or bid.
To be a successful day trader, you can generate equilibrium between the risk-reward ratio and the win-rate ratio by considering all the elements. Your risk-reward ratio should be 1.0 if the win rate is higher, like 60-70%, and for a win rate of 40-50%, it should be around 0.69-0.65.
The ratio of win/loss for Day Trading
Most day-traders’ focus remains on the ratio of win/loss or win-rate to win almost all the trades. Though it is a sensible move, it does not ensure that the win-rate is profitable or the trader’s success.
Win rate is the number of trades won from all the trades made by you. For instance, your win rate will be 60% if you win 3 trades out of 5.
When you divide your wins by losses, then you can get your ratio of win-loss. For instance, 1.5 will be the win-loss ratio if you win 60 trades and lose 40.
So, it will be favorable for you if your win rate is more than 50% and the ratio of win-loss 1.5. But it does not assure you to make you a successful day trader because the value of the loss is more than the value of wins.
Risk/Reward Ratio in day trading
The risk-reward ratio depends upon the amount you expect to earn from trade and how much you can lose willingly.
By using signals and patterns of the trade, day traders usually quickly enter and exit the market. So they will have to attach a stop-loss clause with every trade to show the risk you can take.
For instance, if you are trading for $10.00, then $9.90 will be your stop-loss position if you are ready to lose $0.10.
However, to balance your risk, you will have to establish your expected pay-off with your targeted profits.
Analysis of risk-reward ratio
For instance, $0.20 will be your expected profit if you expect the rise in its price up to $10.20.
In this situation, your reward will be twice your expected losses. So, 0.5 will be your risk/reward ratio.
For day traders, a preferable situation is with a lower ratio of risk/reward as it can maximize their profits.
Balancing between risk/reward and win rate
A balance in risk-reward and win rate is necessary for day traders. With a very high risk/reward ratio, a high win rate is useless. Similarly, a higher ratio of risk/reward is worthless with a shallow win rate.
You will have to consider the following strategies:
It can be a profitable situation if your risk/reward ratio is high with a higher win rate.
You can still earn profits if your ratio of risk/reward and win rate is low.
Peak ratios in day trading
The traders should make a trading strategy to win trades between 50-70% as they have to trade in all conditions. Winning more trades can reduce their profitability.
They should also maintain the ratio of risk/reward of less than 1.0 to make profits.
So it would help if you neither had a very low-risk reward ratio nor a very high win rate to earn profits.