Some of the best traders are profitable on only 40% of their trades. So how can they make money when they are wrong more often than they are right? The answer is the Reward vs. Risk Ratio. That is, they make a lot more on their winning trades than they lose on their losing trades. I know that to most of you this sounds odd as it is more commonly referred to as the Risk vs. Reward ratio. I switched the order of the words because I believe that putting the reward first puts a more positive spin on the principle and this aligns it with a positive psychology that is necessary for successful trading. (Thanks to John Murphy for enlightening me to using the phrase Reward vs. Risk rather than the more common Risk vs. Reward in his Technical Analysis of the Financial Markets book)
So what exactly is the Reward vs. Risk Ratio? It is the ratio of your profit versus your loss. It is calculated by dividing your profit by your loss. To determine your potential profit on a potential trade, you need to know your target price. To determine your potential loss on a potential trade, you need to know your stop price.
Reward vs. Risk Ratio = Profit / Loss
For example if your average profit per trade is $300 and your average loss per trade is $100 your Reward vs. Risk Ratio would be 3:1 or 3 to 1.
Why is the Reward vs. Risk Ratio important? Because it tells you that your potential reward must be a certain multiple of your risk in order for you to even consider the trade. For example if your analysis of where to place your stop (i.e. your risk) dictates that you would place it $2 below your purchase price, your target price (i.e. reward) should be at least $6 above your purchase price (for a 3 to 1 Reward vs. Risk Ratio). Otherwise, you should pass on this trade and look for another opportunity with a better Reward vs. Risk Ratio.
So what is an appropriate Reward vs. Risk Ratio? It is best to try to achieve an actual Risk vs. Reward Ratio of 3:1. 2:1 would be acceptable if you found a strategy that had a high probability of being correct. And unless you like losing money, you would almost never consider trades were the ratio would be 1:1 or less. The reward would not be justified against the risk in these situations. On the flip side, if you only look for trades with a Reward vs. Risk Ratio of greater than 3:1, you will pass up a lot of good trades. The table below list a few example Risk vs. Reward Ratios and the Win vs. Loss Ratios required to just break even (it does NOT take into account commissions or slippage):
|Example 1||Example 2||Example 3||Example 4||Example 5||Example 6||Example 7|
|Reward vs. Risk Ratio:||5.00||4.00||3.00||2.00||1.00||0.50||3.00|
So what does this table tell you? It illustrates that the higher your Reward vs. Risk Ratio is, the lower your % of Winners can be and vice versa. As you can see, if your Reward vs. Risk Ratio is 5:1 (example 1) you only need to be correct on 17% of your trades to break even. On the other end of the spectrum, if your Reward vs. Risk Ratio is a measly 0.5:1 (example 6) you would need to be correct on 67% of your trades to break even. Example 7 is important because it illustrates that if your Reward vs. Risk Ratio is 3 to 1, you are right only 40%, and your average profit per trade is $300, you will make a Net Profit of $600 for every 10 trades you make. If you reduced your Reward vs. Risk Ratio in example 7 to 2:1 and kept all the other variables the same, you would only make a Net Profit of $300 for every 10 trades you make. That represents a 50% drop in profit by reducing the Reward vs. Risk Ratio from 3:1 to 2:1.
Note that when you are applying the Reward vs. Risk Ratio to potential trades, it actually means potential Reward vs. potential Risk. If you donít use a stop, your potential risk is 100%. So when evaluating a potential trade, you need to figure out where your stop should be placed and what you think a reasonable target price would be. Using an ideal 3 to 1 ratio would mean that you would only take on a trade that had a potential reward of 300% versus the risk you would be taking based on your stop. Iím sure that many of you have not thought like this when you put trades on in the past.
In order to be a successful trader, you have to have the probabilities in your favor. Part of the equation of having the probabilities or odds in your favor is only taking trades with acceptable risk reward ratios of 3 to 1 or greater. The bottom line is that if you are risking 100% for a potential profit of 20%, you will not be in this business for very long. Even if you risk 25% for a 25% profit (i.e. 1 to 1) you have to have a winning percentage above 50% just to be profitable and that does not even count overcoming expenses and commissions. If you want to make money in the markets, your Risk vs Reward ratio MUST be greater than 3 to 1. By mostly taking trades with 3 to 1 Reward vs Risk Ratio you adhere to a cardinal rule of trading which is to ďLet your winners run and cut your losses short.Ē