Why Risk vs Reward Is Crucial To Your Trading Success
What is Risk vs Reward in Financial Trading?
Risk to reward is the relationship between the amount you are willing to risk on a trade and the amount of profit you hope to make.
It is a gauge of the potential profit (reward) of a trade compared to the potential loss (risk) that could be incurred if the trade doesn’t go as expected. The Risk to Reward ratio is known as the R/R ratio.
The Risk On A Trade Is The Same As The Stop Loss
By way of example, if the Stop Loss (or risk) for a trade is 50 points away from the entry price and the Profit Target (reward) is 100 points away from the entry price, then the trader is looking to make twice the amount of points as they risked as the Stop Loss. The trade has a 1:2 risk to reward ratio (this means you’re risking 1 to make 2).
Why Risk Vs Reward Is So Important
Working out the risk to reward ratio and defining the maximum loss that you, as a trader, are prepared to incur ahead of entering a trade is crucial, not just for minimising your potential losses, but in the fundamental application of their broader strategy. Knowing the amount that you’re putting at stake and balancing this against the potential reward to be made from their action, enables the trader to decide whether the trade is even worth taking at all.
You’re a responsible adult. You’re not just hoping for the best and holding on for dear life. Defining the risk to reward ratio ahead of entering the trade helps the trader to manage their overall risk. It acts as a safety net; terminating the trade when the Stop Loss is triggered, only in the event that the trade does not go as planned. This protects the trading capital and allows the trader continue trading in the longer term, otherwise, their entire trading bank could be wiped out by just a few hastily placed losing trades. Figure 1 shows a price chart that illustrates the importance of proper risk to reward parameters in a trade.
Figure 1: The importance of having Risk to Reward parameters in place before entering a trade.
How Is Risk to Reward Calculated?
The first step to calculating risk to reward, is to determine the total amount that the trader is prepared to risk (potentially lose) if it the trade goes in the wrong direction. The maximum amount of this is set as the Stop Loss.
The next step is for trader to decide how much profit they want to make from the trade. This is, obviously, the reward. The trader then places the trade using these parameters.
As an example, let’s say there’s is a trade that you’re interested in. We think the price of Utopian Pears is set to go up and want to benefit from this short term upward move in price.
The commodity is currently trading at £20/kilogram.
From studying the charts and doing our homework we believe that the price of Utopian Pears could possibly rise to £45/kilogram, thanks to rising demand and temporary shortages caused by a severe drought in the main agricultural region where its grown.
We decide to buy the commodity at £20/kilogram and want to make a profit of £16. To gain this we are willing to risk £8 as our Stop Loss.
Our trade outlay for the commodity, Utopian Pears, would look like this:
Entry Price: £20.00
Exit Price: £36.00 (16 points above entry price)
Stop Loss: £12.00 (8 points below entry price)
Risk = 8 points
Reward = 16 points
Risk to reward ratio = 8/16 = ½ = 1:2
From the above you can see that the reward is double the size of the risk or, to put it another way, the risk is half the size of the reward. The Risk to Reward ratio is therefore 1:2 (risking 1 to make 2). As you might expect, the lower the risk reward ratio is the better your potential gains.
Should the trade not go as expected, say the price of Utopian Pears falls instead, then the maximum loss that someone taking that trade would incur is £8.
These parameters are defined before entering the trade so that the trader is fully informed before committing; they can place the trade knowing exactly how much they stand to lose should the trade go against them. Depending on the size of the Stop Loss and Profit Target, some trades can have a risk to reward ratio of 1:3; 1:4; 1:5 or even higher.
This might sound obvious, but the aim is to always keep the risk less than the potential reward on any trade. The minimum risk to reward ratio that any trader should aim for is 1:2.
Practical Applications Of Risk to Reward Ratio
As we touched upon earlier, whilst establishing a risk to reward for a single trade can be useful, it is when applying them across a series of trades that it really comes into its own. With a risk reward ratio of 1:2, when you place a trade you only need 40% of your overall trades succeed in order to become profitable.
As an example:
Trading Bank = £5000
Risk Reward Ratio = 1:2
Stop Loss (risk) = £50
Profit Target (Reward) = £100
4 winning trades = £400 profit
6 losing trades = £300 loss
Balance after 10 trades = £100 in profit
A risk to reward ratio of 1:2 requires a 33% win rate to break even (have neither profit or loss) in a trade.
Let’s take a look at another example. The below shows different risk to reward ratios and the win percentages required to make a profit in a sample of 20 trades with a Stop Loss (risk) of 50 points
Risk to Reward Ratio / Percentage of winning trades required to become profitable
1:2 / 40
1:3 / 30
1:4 / 25
1:5 / 20
Careful consideration of the risk to reward should always form a central part of your risk management strategy when placing your trades. It not only helps to protect the trading capital and therefore stops you from getting wiped out by an ill-conceived trade. It improves profitability and ensures your long term survival in the world of trading. Without it, you’re more gambler than a trader and even the luckiest of chancers can get caught out and see all their gains nullified by a string of uncontrolled losses.
With a 1:2 risk to reward ratio, the trader only needs to win 40% of trades to generate profit. With a 1:3 risk to reward ratio, you need only 30% of your trades to bear fruit to become profitable.
No General goes to war without first doing their due diligence; you do your reconnaissance, see what you’re up against and make calculated risks in line with your overall strategy. Likewise, no trader should go into a trade without first correctly identifying and managing their risk.
The Importance Of A Trading Education
Identifying risk, patterns, psychology, routine, personality, strategies, software and training are incredibly important for being able to reliably make money from trading. Whether this is your first time taking on the forces of the market or you’ve had limited success and want to improve that potential, we have a course that’s right for you. If trading sounds interesting to you, then please remember to check out Learn To Trade Online; it’s a FREE one-day training course that we regularly hold and covers day trading, swing trading and many of the basic concepts. Are you ready to start your trading education? Good news, registration is now open for our Pro-Trader Programme! Join now and learn how to generate a reliable second income that fits around your professional schedule or even turn trading into your full-time job. Click here for more information.