How to trade with the risk-reward ratio
There can be a lot of potentially lucrative business opportunities out there, but how do you know which ones will work and which ones will fail? The truth is, you don’t, because all trading involves 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. This helps them determine if 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, it is still possible for the trade to lose money. The risk-reward ratio can be part of the risk management strategy.
How to Calculate the Risk-Reward Ratio
Before learning how to trade with risk-reward, you must 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 from a trade and dividing it by the potential loss. This will leave you with a risk-reward ratio calculation of the amount of reward versus the amount of risk.
The risk is usually left at ‘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 at which you will buy or sell an instrument or asset at
The price where you will take profit
The price at which you expect to cut your losses
The number of assets or instruments you buy
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 falls to $90, they face 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 is determined by the following factors.
The price at which you will buy an asset
The price at which you will profit
The price at which you set your stop loss
In trading derivatives, such as futures and options contracts, as well as contracts for difference (CFDs), two other factors are important in determining potential profits and losses:
For example, suppose Brent crude oil is trading at $100 per 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 profit, but if the price of oil falls to $90, they will accept the loss.
$100 (oil price) x 100 (contract size) x 2 = $20,000 (position size)
$120 (oil price) x 100 (contract size) x 2 = $24,000 (position size) – a profit of $4,000
$90 (oil price) x 100 (contract size) x 2 = $18,000 (position size) – a loss of $2,000
$4,000 / $2,000 = a risk-reward ratio of 2:1
For those looking to avoid the math, another way to calculate the risk-reward ratio is to use a risk-reward calculator, which you can find online.
What is the preferred risk-reward ratio?
When considering a trade, it is important to look at the risk-reward ratio and decide if it is worth taking the risk. If the potential rewards are high and the risk is low, a trade may be worth considering. However, if the potential rewards are low and the risk is high, you might 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 sufficient information on which to base a transaction.
Instead, the risk/reward ratio should be evaluated alongside other variables such as the win/loss ratio (the probability of the trade succeeding) to create a “trade expectation”.
Calculation of win ratio = number of wins / total number of trades
Loss ratio calculation = Number of losses / Total number of trades
The expectation ratio is calculated by multiplying the reward/risk ratio by the win ratio and subtracting it from the loss ratio.
Expectancy Ratio = (Reward-Risk Ratio X Win Ratio) – (Loss Ratio)
An expectation ratio above zero means that in theory the trading strategy could be profitable, while an expectation ratio below zero means it could be a losing strategy.
Why should we look at expectation rather than risk-reward alone? Consider which of the following professions 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 winning at 90%.
How to trade with the risk-reward ratio
You can use the ratio as a filter for trades that match (or don’t match) your trading strategy.
Suppose you are following a swing trading strategy that involves buying stocks after the price has fallen. The strategy works half the time (50% or 0.5), but you only accept trades where the win/loss ratio is at least 2:1. This means that the strategy has an expectation ratio of 0.5 and could be profitable. The calculation is as follows:
Risk/reward ratio = expected gain / expected loss = 2/1 = 2
Expectation ratio according to the 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 breaks below the support for a loss or before the price reaches the resistance for a profit.
Let’s say you set a buy order at $100, a stop loss order 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 want to “add some breathing room” to the stop loss and set it at $94? Then the risk is now $6, bringing the risk/reward ratio to less than 2:1. In this case, you can decide to move the take profit order to $112, making the reward $12 and bringing 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 expectation and is actually a different strategy, which may have different expected results.
Note that markets can be volatile and your decision to trade should depend on your risk tolerance, trading objectives, trading account size and experience in the markets.
Trading tools such as the risk-reward ratio are useful for improving your trading strategy and risk management plan. They should not be used as a substitute for your own research.
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 manuals 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 profit. However, you should always do your own research before trading.
How to read the risk-reward ratio?
The easiest way to read the reward for risk is to compare the potential return of an investment to the amount of risk incurred. 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?
The risk-reward ratio is important to some traders because they use it to decide whether to enter or exit a trade. Whether the risk-reward ratio is an important factor for you will depend on your trading strategy and goals.