A risk:reward ratio can play an essential part inyour trading strategy, and ensure that you're not risking too much of your capital. This lesson teaches you howto use ratios effectively.
In this lesson you can 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 need to divide the amount you stand to lose if the price moves in an unexpected direction (the risk) withthe 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.
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, they don'tgive 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.
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Below we have included a table thathighlights 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
Wementioned probability briefly above, but let’s take a more in-depth look.
Let’s say that out of your last 100 trades, 60 were profitable. That gives you - or your trading system - a probability score of 60%. Probability depends on your trading system, as well as on 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 maximise the chance of entering a high-probability trade. If you look for a specific technical pattern, you are trying to maximise 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 Right 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 risks and rewards 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.
This content has been created by XTB S.A. This service is provided by XTB S.A., with its registered office in Warsaw, at Prosta 67, 00-838 Warsaw, Poland, entered in the register of entrepreneurs of the National Court Register (Krajowy Rejestr Sądowy) conducted by District Court for the Capital City of Warsaw, XII Commercial Division of the National Court Register under KRS number 0000217580, REGON number 015803782 and Tax Identification Number (NIP) 527-24-43-955, with the fully paid up share capital in the amount of PLN 5.869.181,75. XTB S.A. conducts brokerage activities on the basis of the license granted by Polish Securities and Exchange Commission on 8th November 2005 No. DDM-M-4021-57-1/2005 and is supervised by Polish Supervision Authority.
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 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.
Is 1:1 a good RR? ›
And since the 1.5 to 1 reward risk ratio had a good win rate and made a good profit, it is a good idea to use a 1.5 to 1 reward risk ratio in a good trend. Now, remember that even though 1 to 1 reward risk ratio didn't make a good profit in the end, doesn't mean you should completely avoid it.
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).
What is a bad risk reward ratio? ›
In general, traders avoid opening trades that have 1 risk and less than 1 reward ratio. For instance, if you find a trading setup that requires you to place Stop Loss 90 pips away and Take Profit target is 30 pips away, most professional traders will not take the trade.
What is a 1 to 2 risk reward ratio? ›
This indicates that the trader is enthusiastic about going under risk of Rs. 5 for every share to make an expected return go Rs. 10 after closing the deal. Since the trader is likely to make a profit double the risk, the risk-to-reward ratio is 1:2 in this trading.
What is the safest leverage ratio? ›
The best leverage in forex markets depends on the investor. For conservative investors, or new ones, a low leverage ratio of 5:1/10:1 may be good. For seasoned investors, who are more risk-friendly, leverages may be as high as 50:1 or even 100:1 plus.
What is a 2 to 1 profit loss ratio? ›
The higher the number, the better the system is at predicting future price movements. Many investing books suggest a minimum of a 2:1 profit/loss ratio. As an example, a system with a win average of $800 and a loss average of 400$ over a defined time period would have a profit/loss ratio of 2:1.
What is the 1 risk rule in trading? ›
Enter the 1% rule, a risk management strategy that acts as a safety net, safeguarding your capital and fostering a disciplined approach to navigate the market's turbulent waters. In essence, the 1% rule dictates that you never risk more than 1% of your trading capital on a single 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.
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.
Can you be profitable with a 1:1 risk reward? ›
With a 1:1 ratio a trader has to be correct more than 50% of the time to be consistent . So say in a month a trader takes 10 trades with a 1:1 risk reward ratio he has to be profitable in at least 6 trades to make profits for the month . In my opinion a good risk reward ratio is 2:1 or 3:1 .
What does RR of 1.8 mean? ›
A relative risk of 1.8 indicates that those exposed to a certain risk factor are 1.8 times more likely to experience the outcome than those who are not exposed.
Is a 1.5 risk-reward ratio good? ›
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 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 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 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 .
