Money management is the cornerstone of professional trading. Sound and thoughtful money management will help to improve your overall trading performance and significantly cut down your losses.
Managing your money is always about calculating your risks vs. expected returns. The first thing you should do is to decide, how much risk you're willing to take and set all the possible measures to limit your losses. Properly used, stop-losses can be your lifesaver. However, is it enough? Probably not.
So, how to calculate it right?
You decide to buy 10 shares of NVIDIA (NVDA) that cost $228. In order to protect yourself from significant losses you calculate a proper stop level and finally put it at $220. Therefore, your risk per this trade is ($228-$220) x10 = $80.
However, you predict that the NVDA shares will soon go up and will reach the price of $244. This will be taken as your reward target. In this case your potential profit will constitute ($244-$228) x10 = $160.
Calculating the risk-reward ratio here you should divide the risk by reward: 80$/160$ = 8$ x10 shares/16$ x10 shares = 0.5, or 1:2, which sounds rather promising.
The formula for the calculation of the risk-reward ratio for a long position can be as follows:
RRR = (Entry – Stop loss)/(Take profit – Entry)
For a short position, the formula looks like:
RRR = (Stop loss – Entry)/(Entry – Take profit)
When the ratio is <1, your profit outnumbers your risk, otherwise, when it is >1, your risk is rising.
- If the risk is $300 and the expected reward is $600, the RRR is 1:2
- If the risk is $600 and the expected reward is $1800, the RRR is 1:3
- If the risk is $900 and the reward is $450, the RRR is 2:1
Here is the main question: what is a perfect ratio, or at least, what ratio do the experts recommend?
Well, experts suggest that reward should exceed the risk a minimum of twice with the ratios 1:2 and less as the good ones (for new traders a 1:3 ratio is considered a good one). Trades with a reward higher than risk (ratio <1:1), but less than twice (ratio >1:2) are considered too risky. It’s better to avoid a trade with the risk higher than reward (ratio >=1:1).
However, experienced traders are much more concerned about the profitability of their trading experience in general, than the profitability of one single trade.
That’s why it’s very important to understand the interconnection between the risk-reward ratio and your historical winning probability.
In order to make your trading experience profitable you need to get sure that risk-reward ratio doesn’t exceed the maximum risk-reward:
MaxRiskReward = winprob/(1 – winprob).
If your historical winprob is 0.5 (meaning that 50% of all your trades were profitable) then you should enter trades with a risk-reward ratio, that is less than 1:1 to make your trading profitable.
The higher the winprob, the higher the risk-reward ratio can be in order to stay positive. For example, if your winprob is 0.8, it’s possible to have a risk to reward ratio up to 4 (1:0.25) to be a profitable trader.
Cheat sheet for winprob vs. risk-reward ratio
It is worthwhile to remember that with a winprob of 50% and the risk-reward up to 1:1, you may expect that your trading won’t be loss-making. But you’d better search for trades with at least 1:1.5, 1:2 or even lower risk to reward ratio in order to accelerate the growth of your account and to create a buffer.
Please note! If you try to lower your risk-reward ratio making stop losses closer, your trading performance may not magically improve. It’s a bit more complicated. Safe and sound money management strategy covers various aspects. You should place rational stop-losses, always taking volatility into account, and only then make a decision to open a position or not based on whether or not you are satisfied with risk to reward ratio.
Here’s a short action plan for you:
- When opening a position, you should place a proper stop loss. Please, always consider the market's behaviour first! The ATR-method, Bollinger Bands or support and resistance approach can help you make it right, i.e. considering volatility.
- Depending on the expected reward, it’s time to calculate the risk to reward ratioand make sure the chosen trade suits you. You can rely on the common rule of 1:2 ratio, or, if you follow a particular trading strategy, to calculate the historical winprob and define the acceptable risk to reward ratio.
- Further, if you’re satisfied with the risk to reward ratio, you can open a position. Please note that you should define the volume of the position depending on the acceptable risk per trade. Remember that 2% of your capital is considered the most popular and widely applied risk per trade level. However, it's always up to you to decide, whether to risk more or less.
RRR is a clue that opens vast opportunities. Winprob itself standing alone is irrelevant. If your losing trades are too big they can swallow your winning trades. Therefore, you can lose even with an 80-90% winprob. Otherwise, a 30-40% winprob still has a chance for profit. Therefore, always remember to cut your losers short and let your winners run.