Money management is what makes a real difference to your funds. In both everyday life and trading, it is about deciding how to spend your money and how to smooth out any negative outcomes of this spending.
In trading, you are exposed to risk all the time, especially when you trade on margin. Leverage is a magic magnifier of potential earnings, however, it can wipe out your account in a blink of an eye. You can afford bigger trades and rip greater profits, but lose a lot in the meantime.
Sound money management includes stop losses and a risk to reward approach. Stop losses, if set efficiently, can help limit capital losses. The risk to reward ratio (RRR), in turn, shows how much you are ready to lose (risk) on a trade relative to the profit (reward) you expect on this trade. Many traders neglect introducing this metric to their strategy and end up with heavy losses.
The calculation of risk to reward ratio on a single trade is not complicated. Risk is determined using a stop loss level, or the difference between the entry and the exit price should the trade move against you. Reward establishes the difference between the entry and expected exit points in case of favourable price movements.
For example, you go long on one stock priced at €50.40 and set a stop loss at €50.20. Thus, the risk per trade is €50.40 – €50.20 = €0.20. According to your estimates, the stock price will rise to reach €50.80, so you choose this point to be your reward target. The potential profit is €50.80 – €50.40 = €0.40.
Now that we have both the risk and reward, we can calculate the risk to reward ratio per trade: €0.20 / €0.40 = 0.50 (or 1:2). The ratio is less than 1.0, so your potential profit is bigger than risk. If your ratio is more than 1.0, then your risk per trade is greater than reward.
So, what’s the preferred RRR?
It is commonly believed that the best ratio is 1:3 or 1:2. The 1:1 and any other risk reward ratio where risk outweighs reward is not recommended.
However, decreasing the risk to reward ratio by placing tighter stop loss and wider take profit orders does not guarantee better trading performance. Unfortunately, it’s not as simple as that. Reasonable money management implies choosing the right position size and suitable risk per trade, as well as considering volatility when placing stop losses.
After you’ve chosen a market to trade, you have to define a preferable risk per trade level. This is a certain percentage of capital that you can withstand losing on a single trade. 2% is the most common risk per trade. Traders, however, can choose a bigger and a smaller percentage, depending on their risk tolerance.
Bear in mind that you can lose several trades in a row. In such an adverse situation, 2% per one trade turns into 10% of your capital, which evaporates should you lose 5 consecutive trades.
Now that you have defined the risk per trade, it’s time to set a stop loss level.
Active price fluctuations can stop you out prematurely, so market volatility has to be taken into consideration. The trick is to give the market price some space to move. So, if a stock moves €5 a day on average, it’s pointless to place a stop loss at a €3 distance.
There are multiple ways to place volatility-based stop losses: the average true range (ATR) approach, trendline and support/resistance method, Bollinger Bands stop loss method, multiple-day High-Low approach, and more.
FInd more about 2% rule, ATR and support-resistance stop losses in this article.
After you’ve taken the above-mentioned steps, the risk-to-reward ratio comes into play. Take a look at the examples below:
- If you risk €50 hoping for the reward of €100, then the risk to reward ratio is 1:2;
- If you risk €50 hoping for the reward of €1,500, then the risk to reward ratio is 1:3;
- If you risk €100 hoping for the reward of €50, then the risk to reward ratio is 2:1.
Let’s say you are trading one Spotify share. You enter at €135 and intend to gain €20. Thus, €155 is your reward target. Based on the market’s volatility, you place your stop loss at €125. This is €10 below the entry point. This means that you risk €10 to win €20. In other words, the risk per trade ratio is 1:2.
If you’re not satisfied with the RRR, don’t adjust it by placing a tighter stop loss because volatility can stop you out too early. In this situation, it’s advisable to give up on this trade. But if you’re comfortable with the risk-to-reward, proceed with calculating the size of your position. Use this formula:
The reasoning above should be used to figure out whether a trader can or cannot open the position on the instrument given their RRR preferences and risk per trade tolerance.
The bottom line
In fact, there is no such thing as good or bad RRRs, so 1:2 is actually not the best ratio. You can trade profitably even with a RRR of 1:1, but your overall win rate has to be more than 50%. If your historical win rate is 75%, then you can even trade with the RRR of 1:0.3. Overall, the greater your historical win rate is, the more you can afford to risk to keep it profitable.