How to trade with risk reward ratio in focus
There may be a lot of potentially lucrative trading opportunities, but how do you know which will work and which will fail? The truth is you don’t as all trading contains the risk of loss. As a trader all you can do is choose positions where the potential reward justifies the high risks associated with trading. This is where the risk reward ratio comes in.
What is the risk reward ratio and why is it important?
The risk reward ratio is a tool that traders use to assess the potential risk and reward of a trade. The ratio defines the potential reward a trader can earn for every dollar they risk on a trade. It helps them determine whether the potential reward justifies the potential risk.
It is important to remember that the risk reward ratio is not a guarantee of success. Even if the ratio is high, there is still a possibility that the trade could lose money. The risk reward ratio can be a part of risk-management strategy.
How to calculate risk reward ratio
Before learning how to trade with risk reward, you should first be able to calculate the ratio. In its most basic sense, the risk reward ratio in trading is determined by taking the potential profit of a trade and dividing it by the potential loss. This will leave you with a risk reward ratio calculation of the amount of reward relative to the amount of risk.
The risk is usually left as ‘1’. The reward is a multiple of the risk.
Risk reward ratio formula = Potential profit / potential loss
The first step is to calculate your potential profit or loss on a trade. These are determined by:
The price that you will buy or sell an instrument or asset at
The price where you will take profits
The price where you plan to cut your losses
The number of assets or instruments you are buying
For example, a trader decides to buy 10 shares of Microsoft (MSFT) for $100 each. If the price rises to $120, they can close the trade for a profit but if it drops to $90 they are facing a loss.
$120 - $100 = $20 (Potential profit)
$100 - $90 = $10 (Potential loss)
$20 / $10 = 2
This means a risk: reward ratio of 2:1
The potential profit and loss are determined by the following factors.
The price you will buy an asset at
The price you will take profit at
The price where you set your stop loss
In derivatives trading, such as futures and options contracts, as well as contracts for difference (CFDs), two more factors are important to determine potential profit and loss:
The size of the contract
The number of contracts you will trade
For example, say Brent crude oil is trading at $100 a barrel. Each Brent crude oil futures contract is for 100 barrels. An investor decides to buy two contracts. If the price rises to $120 they will take profits but if the oil price drops to $90 they will accept the loss.
$100 (oil price) x 100 (contract size) x 2 = $20,000 (size of position)
$120 (oil price) x 100 (contract size) x 2 = $24,000 (size of position) – a $4,000 profit
$90 (oil price) x 100 (contract size) x 2 = $18,000 (size of position) – a $2,000 loss
$4000 / $2000 = a 2:1 risk reward ratio
For those looking to avoid the maths, another way to calculate the risk reward ratio is to use a risk reward calculator, which you can find online.
What's the preferred risk reward ratio?
When you're considering a trade, it's important to look at the risk reward ratio and decide whether it's worth taking the risk. If the potential rewards are high and the risk is low, then a trade might be worth considering. However, if the potential rewards are low and the risk is high, you may want to rethink the trade.
Industry professionals often cite 2:1 as the optimal risk reward ratio for beginners. The truth is that the ratio by itself is not enough information to base a trade on.
Instead, the risk to reward ratio should be evaluated alongside other variables such as the win loss ratio (the probability of success of the trade) to create ‘trade expectancy’.
Win ratio calculation = Number of wins / Total number of trades
Loss ratio calculation = Number of losses / Total number of trades
The expectancy ratio is calculated by multiplying the reward to risk ratio by the win ratio and subtracting it from the loss ratio.
Expectancy Ratio = (Reward-to-Risk Ratio X Win Ratio) - (Loss Ratio)
An expectancy ratio over zero means that, in theory, the trading strategy could be profitable, while an expectancy ratio under zero means it could be a losing strategy.
Why should we look at the expectancy rather than the risk reward ratio alone? Consider which of the following trades is better to take:
A trade with a risk:reward ratio of 10:1 with a win loss ratio of 5%
A trade with a risk:reward ratio of 5:1 with a win loss ratio of 90%
Trade A has a high risk reward ratio but only a 5% chance of being profitable. Trade B has a smaller risk reward ratio but has a much better chance of being a winner at 90%.
How to trade with risk reward ratio
You can use the ratio as a filter for trades that fit (or don’t fit) into your trading strategy.
Let’s assume you follow a swing trading strategy that involves buying securities after a dip in the price. The strategy works half the time (50% or 0.5), but you only take trades where the win loss ratio is at least 2:1. This means the strategy has an expectancy ratio of 0.5 and could be profitable. The calculation is as follows:
Risk/reward ratio = expected win / expected loss = 2/1 = 2
Expectancy ratio as per formula above = (2 x 0.5) - 0.5 = 0.5
You see a potential trade setup to buy Brent crude oil at $100. There is support at $95 and resistance at $113. You want to exit the trade if the price falls under the support at a loss or before the price reaches resistance for a profit.
Let’s say you set a buy order at $100, a stop loss at $95 and a take profit order at $110. Then the potential profit is $10, the risk is $5 and the risk reward is 2:1.
But what if you wish to ‘add some breathing room’ to the stop loss and place it at $94? Then the risk is now $6, taking the risk to reward ratio under 2:1. In this case you may decide to move the take profit order to $112, making the reward is $12, and taking the trade back to a 2:1 risk reward ratio.
If you take a trade that has a lower risk reward ratio than your strategy dictates, it affects the expectancy and is in effect a different strategy, which may have different expected results.
Final thoughts
Note that markets may be volatile and your decision to trade should depend on your risk tolerance, trading goals, the size of your trading account and how experienced you are in the markets.
Trading tools such as risk-reward ratio are helpful in enhancing your trading strategy and risk-management plan. They should not be used as a substitute for your own research.
FAQs
What is a good risk reward trading ratio?
There is no perfect risk reward ratio, as it will vary depending on your trading strategy and goals. Some trading textbooks suggest starting with a risk reward ratio of 1:2, which means that for every dollar you risk, you expect to make two dollars in profits. However you should always conduct your own research before trading.
How do you read the risk reward ratio?
The simplest way to read risk reward is to compare the potential return of an investment to the amount of risk involved. The risk reward ratio compares the potential loss to the potential reward. For example, if the potential loss is $100 and the potential reward is $200, the risk reward ratio would be 1:2.
Is risk reward important in trading?
Risk reward ratio is important for some traders as they use it to make decisions about whether to enter or exit a trade. Whether risk reward ratio is an important factor for you would depend on your trading strategy and goals.
