A risk:reward ratio can play an essential part inyour trading strategy, and ensure that you're not risking too much of your capital. This lesson teaches you howto use ratios effectively.
In this lesson you can learn:
- Why reward:risk probability is important in trading
- What are the most popular reward:risk ratios
- Why probability is the key to every trading strategy
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 need to divide the amount you stand to lose if the price moves in an unexpected direction (the risk) withthe 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.
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, they don'tgive 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.
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Below we have included a table thathighlights 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
Wementioned probability briefly above, but let’s take a more in-depth look.
Let’s say that out of your last 100 trades, 60 were profitable. That gives you - or your trading system - a probability score of 60%. Probability depends on your trading system, as well as on 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 maximise the chance of entering a high-probability trade. If you look for a specific technical pattern, you are trying to maximise 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 Right 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 risks and rewards 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.
This content has been created by XTB S.A. This service is provided by XTB S.A., with its registered office in Warsaw, at Prosta 67, 00-838 Warsaw, Poland, entered in the register of entrepreneurs of the National Court Register (Krajowy Rejestr Sądowy) conducted by District Court for the Capital City of Warsaw, XII Commercial Division of the National Court Register under KRS number 0000217580, REGON number 015803782 and Tax Identification Number (NIP) 527-24-43-955, with the fully paid up share capital in the amount of PLN 5.869.181,75. XTB S.A. conducts brokerage activities on the basis of the license granted by Polish Securities and Exchange Commission on 8th November 2005 No. DDM-M-4021-57-1/2005 and is supervised by Polish Supervision Authority.
FAQs
In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
Is 1:1 a good RR? ›
A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit. For trading to prove profitable in the long term, a trader should not typically risk their capital for a lower risk/reward ratio, as this will mean that half or more of their investment could be lost.
What is a 1.5 risk reward ratio? ›
The 1.5 Risk-Reward Ratio: Balancing Risk and Reward
A commonly cited benchmark in trading is the 1.5 risk-reward ratio. This ratio suggests that for every unit of risk taken (usually measured as a percentage or dollar amount), an investor should aim for a potential reward that is one and a half times greater.
How to calculate risk reward probability? ›
To calculate risk-reward ratio, divide net profits (which represent the reward) by the cost of the investment's maximum risk. For instance, for a risk-reward ratio of 1:3, the investor risks $1 to hopefully gain $3 in profit. For a 1:4 risk-reward ratio, an investor is risking $1 to potentially make $4.
What is the best risk reward ratio for scalping? ›
For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).
What should be the risk reward ratio for swing trading? ›
A common approach for setting profit targets in swing trading is to aim for a minimum reward-to-risk ratio of 3:1, meaning that for every percentage point risked, the trader aims to make three times that amount.
What does RR of 1.8 mean? ›
For instance, if the relative risk of acquiring a disease is 1.8 for a certain group of people, it implies that their chance of getting the disease is 1.8 times higher than those who have not been exposed to the risk factor.
How to interpret RR 1? ›
A relative risk of one implies there is no difference of the event if the exposure has or has not occurred. If the relative risk is greater than 1, then the event is more likely to occur if there was exposure.
What is the win rate for professional traders? ›
Winning 5 out of 10 trades is a 50% win rate. Winning 30 out of 100 is a 30% win rate. Most professional traders have a win rate near 50% or less. They are profitable because they make more on winning trades than they lose on losing trades.
What does 2R mean in trading? ›
This enables traders to express profit and loss as a ratio of R. An example might be a trade with 1R risk of 100 USD which returns 200 USD on winning trades, on average: a 2R return—a R multiple of 2. The same is said for losses.
A lot of day traders follow what's called the one-percent rule. Basically, this rule of thumb suggests that you should never put more than 1% of your capital or your trading account into a single trade. So if you have $10,000 in your trading account, your position in any given instrument shouldn't be more than $100.
How to use rrr in tradingview? ›
Using Pinescript to create custom Risk Reward Ratio (RRR) boxes with custom vertical time markers to help traders stay mindful of how long they've been in a trade. //Usage: -Add indicator to chart and you'll be prompted to click three times: -- 1: Choose time (clicking last bar will mark entry as current candle's open) ...
What is a good risk to reward ratio in trading? ›
This is the same risk/reward ratio that you can get in casino games like roulette, so it's essentially gambling. Most experienced traders target a risk/reward ratio of 1:3 or higher.
How to calculate RR in trading? ›
The risk/reward ratio is measured by dividing the distance from your entry point to Stop Loss and the distance from your entry point to Take Profit levels. The relationship between these two numbers helps traders define whether the trade is worth it or now.
How to use probability in trading? ›
However, you also need to consider the probability of reaching your target and the frequency of your trades. A trade with a high risk-reward ratio may have a low probability of success, or it may occur rarely. Therefore, you need to balance your risk-reward ratio with your win rate and your trading frequency.
What is good risk reward ratio in trading view? ›
The most typical example of risk/reward ratio is 1:2, which means that for every $1 you risk, you expect to make $2. It is the minimum requirement for most traders, as a lower ratio would cause you to lose in the long run. Many long-term traders even use higher ratios such as 1:3 or 1:4.
What is the best risk percentage for trading? ›
The simplest and most effective way to protect your equity through risk management is to establish strict loss parameters and abide by them. One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1).
What is the 1 3 ratio in trading? ›
Risk-Reward Ratio (1:3): For every trade you take, you are willing to risk 1 unit of your capital (e.g., $100) to potentially gain 3 units (e.g., $300) if the trade goes in your favor. Now, let's consider the win rate: 2. Win Rate: This represents the percentage of your trades that are profitable.
