“It‘s not whether you’re right or wrong that‘s important, but how much money you make when you’re right and how much you lose when youre wrong.” – George Soros
Meet Alex.
Alex‘s trading performance has been choppy at best and he’s looking for ways to achieve consistent profitability.
After scanning trading-related forums, Alex stumbled upon the term “reward-to-risk (R:R) ratio,” and learned from other traders that using a high R:R ratio would increase his chances of booking profits.
He tries it on his long EUR/USD trade and aims for 50 pips using a 25-pip stop. Unfortunately, the pair only moved 30 pips in his favor before it dropped back down to his initial stop loss.
Thinking that his stop was simply too tight, he revises his strategy and widens both his target and his stop. He now aims for 150 pips with a 50-pip stop.
But, since Alex is not a good trader to begin with, he misjudges EUR/USDs upside momentum and the pair only moves 55 pips higher before dropping back down to his entry area and he ends up closing with only a 5-pip gain.
Does Alex‘s story sound familiar to you？ If it does, don’t worry. Its common enough for newbie and pro traders alike to use wide stops and targets to increase their chances of being right. However, as the scene above suggests, this strategy can also be detrimental to your trading account.
Remember that reward-to-risk ratio is simply the comparison of your potential risk (distance from your entry to your stop loss) and your potential reward (distance from your entry to your profit target).
In the example above, Alex first used a 2:1 risk ratio before he bumped it up to a 3:1 R:R ratio. If the latter trade had worked out, Alex wouldve bagged pips three times the size of what he risked.
The main appeal of higher risk ratios is that it increases your trading expectancy, or the amount you gain (or lose) per trade.
This means that there‘s less pressure with every loss, as you’ll only need to be right a few times to cover the losses from your other trades.
Unfortunately, a lot of traders use higher risk ratios to cover poor trade execution. This is problematic because its not that easy to make risk ratios work for you to begin with.
For one thing, aiming for a higher/lower profit target would mean that price would have to travel farther than in setups with lower risk ratios. Using stops that are too tight, on the other hand, would kick you out too early and too often to be sustainable.
So, how do you find a R:R ratio that works for you？
While theres no Holy Grail to finding the perfect reward-to-risk ratio, a good place to start is to look at your win rate.
It makes sense, dont you think？ Before you can expect your risk ratio to work for you, you must first confirm that you CAN win often enough to eventually hit that potential reward.
For example, using a 1:1 risk ratio means that your potential profit is as big as your potential loss. This will only work out if youre right AT LEAST half the time historically.
Using a 3:1 risk ratio, on the other hand, means that potential profits are three times as large as potential losses, so you only have to be right at least 25% of the time to be profitable.
Here are handy formulas if you want to play around with win rates and risk ratios:
Required risk ratio = (1 / win rate) – 1
Minimum win rate = 1 / (1+ risk ratio)
Using the formulas above, we can confirm that the required win rate for a 1:1 risk ratio is at least 1 / (1+1) = 0.50%.
Likewise, if you only have a win rate of 40%, then youll have to find trades that have at least (1/0.4) – 1 = 1.5:1 reward-to-risk ratio to be sustainable in the long-term.
Taking it one step further, we can see that it IS possible to use less than 1:1 risk ratio provided that you have a fantastic win rate. For example, you can use a 0.4:1 risk ratio if you win your trades at least 1 / (1+0.4) = 71% of the time. Easy peasy, right？ RIGHT？!
Before you compute for a more personalized risk ratio for you and stick to it like glue, you should keep in mind that using win rates to find a good risk ratio barely scratches the surface.
If you want to get a more appropriate ratio for your trade, you can also get information from your expectancy, the current trading environment (high risk ratios fare better on trends), and the currency pairs average volatility range.
As with a lot of things in forex trading, there‘s no single reward-to-risk ratio that will work best for every trader and every trade. But, as long as you mind your odds and work on managing your risk, then you’ll eventually find a way to make profits consistently.
Source:babypips
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