Risk-Reward

If you’re trading, there’s no end of facts that you’re told you should know. Log on to your average forum, and there are plenty of traders who’ll make it their business to belittle you for your lack of knowledge on Gann theory or Ichimoku charts …

In reality, it’s not about how much you know … but how effective you are at applying what you’ve got.

If you’re great at drawing on lines of support and resistance – it really doesn’t matter if you don’t know how to read an oscillator.

However, there are a few key things that every trader should be aware of when placing a trade …

And one of those things we need to know is “risk-reward”.

Risk-reward is simply how much you’ll risk on a trade compared to how much you could potential gain from that trade. Here I’ll show you the simple way to work this out …

However, first I’ll ask you to indulge me in a little rant

Talking about risk reward ratios (RRR) will inevitably get me onto one of the pieces of perceived market “wisdom” that really get my back up.

Today’s rant is about the trading “wisdom” that you should only follow trades with a risk reward ratio of at least 2:1. (i.e. you should have a potential reward of at least £2 for every £1 risked.)

In my opinion, this is foolhardy – rather like standing at the racecourse and always throwing your money at the 50/1 outsider, because you won’t make enough return on the favourite that’s just raced home at 3/2 – again!

The proponents of the 2:1 rule, will often glibly tell you that you can then “be wrong more than half the time, and still make money!” However, we’re not betting on the toss of a coin – placing a trade is much more complex, and there are so many different ways in which we can get it wrong (timing … stop levels … profit targets) – anyone who’s traded for just as short time will know how easy it is to be ‘almost right’.

But ‘almost right’ doesn’t cut it. And any genuine trader will know that a 2:1 risk reward ratio is incredibly hard to maintain without very smart risk-management methods.

Understanding risk-reward

Risk-reward is an extremely important concept in trading. Too many traders don’t fully understand it, and blindly follow advice about 2:1 ratios – at their peril.

However, if you can get a grip on your risk-reward factor, you can effectively use it to your advantage in trading.

The “risk” part is how much you would expect to lose if your trade is unsuccessful.

The “reward” is how much you expect to gain if your trade is successful.

So, the risk-reward ratio is one of these figures against the other. So, if you’re risking £1 to make £2, your risk-reward ratio is 2:1. That’s £2 profit, for every £1 risked.

How to calculate your risk reward ratio

To work out what your risk-reward is on any given trade, ask yourself these two questions:

1. If I’m correct and the trade wins, how much do I expect to earn?

2. If I’m wrong and the trade loses, how much do I expect to lose?

Let’s say that I see a great opportunity on the GBP/EUR at 1.200, and I believe that the currency will rise 1.250, offering 50 pips profit. To give my trade room to breathe, I put my stop loss below the previous day’s low, at 1.150. That means that my stop is 50 pips away from my entry point.

So, my potential reward is 50 pips, and my potential risk is 50 pips – 50/50. That gives me a risk-reward ratio of 1:1.

Let’s take another example …

This time, I’ve seen a great play on the FTSE, at 6810, and I think that the market will rise by 80 points to 6890. There’s strong resistance around 5800, so I put my stop loss just below the resistance at 5790.

This time, my potential reward is 80 points, but my potential risk is just 20 points – 80/20. So my risk-reward ratio is 4:1.

Letting the tail wag the dog

The first problem that arises if we get too hung up on risk-reward ratios, is that they can make ignore prices.

Let’s go back to that trade of mine on the GBP/EUR …

This time, just before I place my trade I remember that I read somewhere (possibly in “Trading for Dummies”) that my risk-reward ratio shouldn’t be lower than 2:1.

What can I do?

Well, many traders will “fiddle” the trade to fit this philosophy.

Now, I’ll still enter at 1.200, with a target of 1.250 (50 pips potential reward), but this time, rather than setting my stop loss at the previous day’s low, instead I’m setting it at 1.175 (just 25 pips risk).

This time, my potential reward is 50 pips, and my potential risk is 25 pips – 50/25. Which gives me my tidy risk-reward ratio of 2:1.

However, now my stop level is just above the previous area of support – making it many times more vulnerable.

I may be following “perceived wisdom”, but I’m running a serious risk of getting bumped out of my trade by a little market “noise”. And that’s where we see the shortcomings of risk-reward ratios – they simply can’t give us the whole picture of the risks involved …

– they can’t factor in the added risk involved in an inappropriately placed stop loss or profit target.

– they can’t factor in the benefits of reducing your risk in other ways (like diversification and hedging).

– and, of course, they don’t give any information about the success rates of a trade.

Which brings me onto the most important thing to remember with risk-reward ratios, is that they tell us nothing about profitability without one extra crucial piece of information …

… probability (or success rate). Which brings me neatly onto …

Words you need to know #2: Probability

Related posts:

Follow this “trading wisdom” at your peril Balancing risk and reward: what’s the best risk to reward ratio?