“It is not important whether you are right or wrong, but how much money you make when you are right and how much you lose when you are wrong.” – George Soros
Meet Alex.
Alex’s trading performance has been choppy at best as he looks for ways to make a consistent profit.
after scanning Trading related forumsAlex stumbled upon the term “reward-to-risk (R:R) ratio”, and learned from other traders that using a high R:R ratio would increase his chances of making a profit.
He tested it in a long EUR/USD trade and aims for 50 pips using a 25 pips stop. Unfortunately, the pair only moved 30 pips in its favour, before retracing to the initial stop-loss level.
Believing his stop was too narrow, he revised his strategy and widened both his aim and stop. It now aims at 150 pips with a 50 pips stop.
But since Alex is not a good trader to begin with, he misjudged EUR/USD’s bullish momentum and the pair moves only 55 pips higher before falling back to its entry zone and ending up closing with only 5 pips in profit.
Does Alex’s story sound familiar to you?
If so, don’t worry. It is common enough for both novice and professional traders to use wide stops and targets to increase their chances of being right.
However, as the above scene suggests, this strategy can also be harmful to your trading account.
Remember, the reward-to-risk ratio is simply a comparison of potential risk (the distance from your entry to your stop loss) and potential reward (the distance from your entry to your profit target).
In the example above, Alex first used a 2:1 risk ratio before raising it to a 3:1 R:R ratio. If the latter trade had been successful, Alex would have earned three times as much pips as he risked.
The main advantage of higher risk ratios is that they increase your trading expectation, or the amount you earn (or lose) on each trade.
This means there is less stress with each loss, eg You will only need to be right a few times to cover the losses from your other trades.
Unfortunately, many traders use higher risk ratios to cover for poor trade execution. This is problematic because it is not easy to get risk ratios to work for you to begin with.
For one thing, aiming for a higher/lower profit target means that the price will have to travel further than it would in settings with lower risk ratios.
On the other hand, using stops that are too tight would knock you out too early and too often to be sustainable.
So how do you find the R:R ratio that works for you?
While there is no holy grail for finding the perfect reward/risk ratio, the best place to start is by looking at your account win rate.
It makes sense, don’t you think? Before you can expect your risk ratio to work for you, you must first confirm that you can win often enough to finally realize this potential reward.
For example, using a 1:1 risk ratio means that your potential profit is as large as your potential loss. This will only work if you are right at least half the time historically.
On the other hand, using a 3:1 risk ratio means that the potential profits are three times greater than the potential losses, so you only need to be right at least 25% of the time to be profitable.
Here are some useful formulas if you want to play around with profit rates and risk ratios:
Required risk ratio = (1 / win rate) – 1
Minimum profit rate = 1 / (1 + risk ratio)
Using the above formulas, we can assert that the required win rate for a 1:1 risk ratio is at least 1 / (1 + 1) = 0.50%.
Similarly, if you only have a 40% win rate, you will have to find trades that have at least (1/0.4) – 1 = 1.5:1 reward-to-risk ratio to be sustainable in the long run.
Taking it a step further, we can see that it is possible to use a risk ratio of less than 1:1 provided you have a great win rate.
For example, you can use a risk ratio of 0.4:1 if your trades win at least 1 / (1 + 0.4) = 71% of the time. Easy, right? right?!
Before you calculate a more personalized risk ratio and stick to it like glue, you should keep in mind that using win rates to find a good risk ratio barely scratches the surface.
If you want to get a more suitable ratio for your trading, you can also get information from your forecast, current trading environment (higher risk ratios match better with trends), and the average volatility range of the currency pair.
As with a lot of things in forex trading, there is no single reward-to-risk ratio that works best for every trader and every trade. But, as long as you pay attention to your chances and work to manage your risk, eventually you will find a way to make profits consistently.