The Risk : Reward Ratio

As a new trader, you have probably heard people talk about the risk : reward (R:R) ratio more than once, with advice such as: “you need a good R:R ratio above 1” or “professional traders usually have a minimum R:R ratio of 1:2“… But that is only one side of the story.

You can take trades with a 1:2 risk : reward ratio and still be a consistently losing trader (and I will prove it to you shortly). Likewise, you can take trades with a risk : reward ratio below 1 and still be consistently profitable. Why? In this article, I will give you the full picture so you understand how to use the risk : reward ratio properly. Here is what we will discuss:

• What is the risk : reward ratio, really?
• The secret to finding your edge (hint: the risk : reward ratio alone is not enough)
• How to set a proper stop-loss and define your risk limit.

What is the risk : reward ratio, really?

The risk : reward ratio measures how much you can potentially earn for every dollar you risk. For example:

If you have a risk : reward ratio of 1:3, you are risking $1 to potentially make $3.

If you have a risk : reward ratio of 1:5, you are risking $1 to potentially make $5. You see what I mean? Now here is the biggest lie you have ever heard about the risk : reward ratio.

“You need a risk : reward ratio of at least 1:2.” Why is that a lie? Because the risk : reward ratio on its own is meaningless. Here is an example:

Suppose you have a risk : reward ratio of 1:2 (for every winning trade, you make $2). But your win rate is 20%. So out of 10 trades, you have 8 losers and 2 winners.

Let’s do the maths…

Total losses = $1 × 8 = –$8

Total gains = $2 × 2 = $4

Net loss = –$4

Now I hope you understand that the risk : reward ratio on its own is a meaningless measure. Instead, you must combine your risk : reward ratio with your win rate to know whether you will make money in the long run (this is called your trading expectancy).

The secret to finding your edge (hint: the risk : reward ratio alone is not enough)

Here it is…

E = [ 1 + ( W / L ) ] x P – 1

Where:

W is your average win

L is your average loss

P is your win rate

Here is an example: you take 10 trades. Six win and four lose. That means your win rate is 6/10, or 60%.

If your six winning trades make you $3,000, your average win is $3,000 / 6 = $500.

If your four losing trades cost you $1,600, your average loss is $1,600 / 4 = $400.

Next, plug these numbers into the expectancy formula:

E = [ 1 + ( 500 / 400 ) ] x 0.6 – 1 = 0.35, or 35%.

In this example, your trading strategy’s expectancy is 35% (a positive expectancy).

This means your trading strategy will make $0.35 for every dollar you trade over the long run. So here is the truth:

There is no such thing as “a minimum risk : reward ratio of 1:2”.

Because you can have a risk : reward ratio of 1:0.5 and, if your win rate is high enough… you will still be profitable in the long run. The most important metric in trading is not the risk : reward ratio or the win rate. It is your trading expectancy.

Your trading expectancy

You can calculate your own trading expectancy by keeping a trading journal over a long enough period – at least three to six months. You can then calculate your win rate and your average profit/loss per trade. Keep an eye on your trading expectancy: whether it improves or declines will show you whether your trading is getting better. 

Happy Trading !

The “Stock Trading For A Living” Course

Green Chart designed this course to give students a solid foundation in fundamental analysis and stock valuation, and to show them how to integrate it effectively into their existing trading system, especially for traders who already use technical analysis. The programme includes five theory sessions and six months of hands-on trading practice in the real market with the lecturer.

See full course details here.