A risk:reward ratio can play an essential part of your trading strategy and ensure that you're not risking too much of your capital. Learn how to use ratios effectively .
In this lesson you’ll learn:
- Why reward:risk probability is important in trading
- What are the most popular reward:risk ratios
- Why probability is the key to every trading strategy
A risk:reward ratio is utilised by many traders to compare the expected returns of a trade to the amount of risk undertaken to realise the profit. To calculate the risk:reward ratio, you divide the amount you stand to lose if the price moves in an unexpected direction (the risk) by the amount of profit you expect to have made when you close your position (the reward.)
Some of the most popular reward:risk ratios are 2:1, 3:1 and 4:1 and these will change depending on the strategy of the trade. Of course there are other aspects which may affect the risk of a trade, such as money management and price volatility but having a solid reward:risk ratio can play a strong role in helping you to manage your trades successfully.
An example of a risk:reward ratio
Let’s say that you decide to go long on ABC shares. You ‘buy’ 100 lots, equivalent to 100 shares, which are priced at £20 for a total position value of £2,000 - on the basis that you believe the share price will reach £30. You set your stop loss at £15 to ensure that your losses do not exceed £500.
In this case then, you’re willing to risk £5 per share to make an expected return of £10 per share after closing your position. Since you’ve risked half the amount of your profit target, your reward:risk ratio is 2:1. If your profit target is £15 per share, your reward:risk ratio would be 3:1, and so on. Therefore, it’s possible that one profitable trade will cover two, three (or more) losing trades.
It’s important to remember however, that while risk:reward ratios helps to manage your profitability, it doesn’t give you any indication of probability.
The importance of a risk:reward ratio
Most traders aim to not have a reward:risk ratio of less than 1:1 as otherwise their potential losses would be disproportionately higher than any likely profit i.e. a high-risk trade. A positive reward:risk ratio such as 2:1 would dictate that your potential profit is larger than any potential loss, meaning that even if you suffer a losing trade, you only need one winning trade to make you a net profit.
Below we have included a table below to highlight different reward:risk ratios and their impact on your total profits and losses. The table below assumes 1 is equal to £100 and you have a win rate of 50% across 10 trades.
You can see clearly from the table below the potential benefits of having a positive reward:risk ratio and how this can impact your net profitability.
Probability is key:
We mentioned probability briefly above, but let’s take a more in-depth look.
Let’s say out of your last 100 trades, 60 were profitable. That gives you - or your trading system - a probability of 60%. Probability depends on your trading system as well as your emotional ability to stick to that system.
What’s more, the main objective of every analysis made ahead of entering the market is to maximize the chance of entering a high-probability trade. If you look for a specific technical pattern, you are trying to maximize a probability. Why? Because as it appears it should be followed by a specific move of the price. By searching for a pattern you are potentially increasing your chances of finding a higher probability trade.
Choose the one for you:
Each trader has their own trading strategy and risk-reward ratio that is the most suitable for them. One of the challenges of trading is finding a system that works for you and one that ‘fits’ your mindframe.
If we think about risk tolerance on a spectrum, where do you think you would be? Are you risk-averse, cautious and calculated? Or are you open to taking more risk and enjoy the adrenaline?
The most important thing is to choose a system of risk and reward that is manageable for you and that potentially increases the chances of your trading being as successful as possible. There’s no specific rule - you just have to find a perfect one that suits your strategy.
FAQs
In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.
What is the risk to reward ratio for professional traders? ›
Usually, Forex traders take trades with 1:2, 1:3 risk to reward ratios or higher. However, it is also possible to make money even when your risk to reward ratio is just 1:1.
What is the risk reward ratio in XTB? ›
To calculate the risk:reward ratio, you divide the amount you stand to lose if the price moves in an unexpected direction (the risk) by the amount of profit you expect to have made when you close your position (the reward.)
What is the best risk reward ratio for positional trading? ›
A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit. For trading to prove profitable in the long term, a trader should not typically risk their capital for a lower risk/reward ratio, as this will mean that half or more of their investment could be lost.
What is the best risk reward ratio for scalping? ›
For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).
Is 2 a good risk reward ratio? ›
A reasonable risk-to-reward ratio is 1:2, which indicates the profit or reward is higher than the loss. The trader has assured a substantial break-even profit margin when the trading suffers any loss.
How to use rrr in tradingview? ›
Using Pinescript to create custom Risk Reward Ratio (RRR) boxes with custom vertical time markers to help traders stay mindful of how long they've been in a trade. //Usage: -Add indicator to chart and you'll be prompted to click three times: -- 1: Choose time (clicking last bar will mark entry as current candle's open) ...
What is the 1.5 risk reward ratio? ›
The 1.5 Risk-Reward Ratio: Balancing Risk and Reward
A commonly cited benchmark in trading is the 1.5 risk-reward ratio. This ratio suggests that for every unit of risk taken (usually measured as a percentage or dollar amount), an investor should aim for a potential reward that is one and a half times greater.
What does 2R mean in trading? ›
Here's another example: Let's say you buy a stock priced at $500 and have a stop loss at $480, meaning that 1R is equal to $20. Then the stock's price increases to $540 and you take profit. You have taken $40 or 2R profit.
How to increase probability in trading? ›
That means looking at the risk to reward ratio before entering a trade, making sure that you have a large enough account to take the risk, and if you don't, stand aside and wait for a trade you can take. Risk management is a trader's secret weapon, and you must use is to survive over the long haul.
A positive reward:risk ratio such as 2:1 would dictate that your potential profit is larger than any potential loss, meaning that even if you suffer a losing trade, you only need one winning trade to make you a net profit.
How to use probability in trading? ›
However, you also need to consider the probability of reaching your target and the frequency of your trades. A trade with a high risk-reward ratio may have a low probability of success, or it may occur rarely. Therefore, you need to balance your risk-reward ratio with your win rate and your trading frequency.
What is the 1 risk rule in trading? ›
The 1% risk rule means not risking more than 1% of account capital on a single trade. It doesn't mean only putting 1% of your capital into a trade. Put as much capital as you wish, but if the trade is losing more than 1% of your total capital, close the position.
How do you risk 1% per trade? ›
Applying the 1% Rule in a Single Trade
Calculate 1% of your risk capital. This is the maximum amount you're allowed to risk on any single trade. For example, if you have £10,000 in your trading account, the maximum risk per trade is £100.
Where is risk reward ratio in TradingView? ›
Use TradingView charts to determine the risk/reward ratio
It is on the left side of your chart. Click on the tool as is shown below, and choose Long position if you want to buy and Short position if you want to sell. So, we choose a Long position and click on the spot in the chart where we want to buy BTC.
What is a good risk per trade? ›
Risk per trade should always be a small percentage of your total capital. A good starting percentage could be 2% of your available trading capital. So, for example, if you have $5000 in your account, the maximum loss allowable should be no more than 2%. With these parameters, your maximum loss would be $100 per trade.
What is 1 1 risk reward ratio in trading? ›
A 1:1 risk reward ratio means that a trader is risking the same amount for making that same amount of money . So having a stop loss of 50 pips with a target price of 50 pip profit is an example of 1:1 risk reward ratio . So a trader is risking 50 pips to make 50 pips .
Is a higher risk reward ratio better? ›
So the general rule is a risk-to-reward ratio of over 1.0 means the possible risk is greater than the possible reward, and anything below 1.0 means the possible profits are greater than the potential risk.
