How you can use the Risk Reward Ratio to your Trading
Although at a first glance it seems pretty simple and straight forward, applying Risk/Reward Ratio to your trade takes some serious homework and lots of fine tuning to achieve good results.
First to explain what is actually Risk/Reward Ratio in Trading :
- It is a ratio between your risk (how much are you ready to lose) vs Reward ( how much you want to win )
It all starts from there…
But it is not as simple as one might think , and I am going to give you here not only some rules, but examples as well.
To be able to find the R/R that suits your needs, trading style, strategy and the system you use you have to start from the system.
You have to do a thorough back testing of your System.
Find out the following:
- How many winning trades it makes for as long as you can go back in time
- How many losing trades
- What is an average pull back from your entry level
- What is an average Profit it makes in any given trade
Now you will get a first important info on your trading : Probability
So how to calculate a Probability of your system :
- You had 140 winning trades and 60 losing one’s – 200 trades in total
- Divide (140:200) x 100 =70 – your Probability is in your favour and it is 70%
- Do not start immediately with the idea that from 10 trades you’ll be winning 7 – it might not happen like that at all…you might have 7 losing trades in a row , followed by 20 winning trades…or anything in between.
- This is a Probability of your system on the long run
Once you determine that your system gives positive results , you move to the R/R
For Risk – Reward to be on the safe side, it has to be at least 1:1,5 , but what you are looking for is over 1:2
What does that mean :
- R/R 1:2 means that on every dollar you risk you expect 2 dollars of profit
- In case your Probability is 50% for example – you lose 50$ and win 100$
- As Probability is higher , your chances grow exponentially
But pure math is not enough , as you cannot go just with your wishes – you have to face the reality
This is where your back testing comes to play:
-
You determine the real outcome of your system’s trades and apply it to your R/R
Example:
- 140 winning trades – 60 losing ones
- Average pull back from your entry point is 5 pips
- Average Profit of any given winning trade is 20 pips
Based on this, you first determine where your stop loss should be
- You go with 8-10 pips for stop loss ( so a bit more than your average pull back from the entry level)
- To make this easier to calculate we go with 10 pips stop loss
As your average profit is 20 pips we got the following:
- 10 pips stop / 20 pips profit target = R/R 1:2
- With a Probability established at 70% , on 100 trades you are looking at the following :
- Loss 300 pips / Profit 1.400 pips
- In the case of higher probability, as I said earlier already it grows significantly.
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