How to Use the Risk/Reward Ratio in Trading

Taking Risks To Reap Rewards

Are you tired of losing on trades and want to develop new strategies? Well, the following article might be useful. 

Let’s talk about Risk and Rewards.

Every trader deals in risk, and hopes to profit on it. But what is it really, in concrete terms?

Risk is the amount of invested capital that a trader can potentially lose, while Reward is the potential profit.

Risk/Reward is shown as a ratio and means the amount of profit a trader can expect to gain on a position, depending on how much the trader is willing to risk on a loss. Understanding this ratio gives traders the ability to better hedge and manage their risk.

An example of risk can look something like this: a long trade on BTC/USD that requires a stop-loss of .05 USD, and has a take-profit set at .10 USD represents a 1:2 risk/reward ratio. That is, we’re risking a loss of .05, and expecting to double it in the case of a win. Doubling that to .20 USD would be 1:4. 

Any trader worth their salt knows that risk/reward ratios are only approximations, and are never a hard rule. Everyone has different trading environments, timeframes, risk tolerances.


Few More Examples To Really Nail Down the Risk/Rewards Ratio

If you’re the type of person who generates a small profit over a large number of trades, then you probably have a risk/reward ratio close to 1:1. In other words, you have a low risk/reward ratio. If you have more winning trades than losing ones and your risk/reward ratio close to 1:1, then you’ll be able to generate consistently profitable results over a large number of trades.

If you execute ten trades a day with a 1:0.15 risk/reward ratio, you would need to win every seven or more trades out of ten to achieve profitability in trading. That might seem difficult, but a trading strategy like that is looking at the overall volume of trades then each individual one. Do keep in mind that you might lose out if you’re not accounting for interest and commissions.

For someone who takes a longer view, let’s say anywhere from two days to two weeks, you may not need such a high win ratio. It’s a valid medium-term strategy, as the risk/reward is usually healthier than the previous strategy. That’s because when you’re aiming for a larger gain, the win rate typically decreases. Medium-term traders like that will often go for at least a 1:1.5 risk/reward ratio, meaning that you would only need to win 5 out of every 10 trades to turn a profit.

A lot of the time, many traders get easily disheartened by a few losses and stop trading entirely. Focusing on your risk/reward ratio, and having the patience to constantly execute a large number of trades, is a much more profitable proposition. Winning trades doesn’t matter if that’s the only metric you’re looking at.


The Importance Of Looking at the Risk/Reward Ratios For Your Trades

  • New traders often focus on their win/loss ratio over their risk/reward, which is a huge mistake. Trade with a bad risk/reward ratio, but a high win ratio can still end up in the red.
  • Consistent risk/reward ratios can help mitigate losses over time.
  • High-probability trades are easier to locate with a measured risk/reward ratio. 
  • Don’t trade every day. Even if you only make ten trades a month with a risk/reward ratio of 1:3, you only have to win seven of those trades to turn a profit at the end of the month. If your risk/reward is set correctly, then you shouldn’t get too involved with your trade output and win ratio.


To Wrap Up

Losing a trade can be hard to take. But don’t let that steer you away from trading. Focus instead on the risk/reward ratio in your trades - even if you win only 30% of your trades, with the right risk/reward, you can still turn a profit. Losses are part and parcel of trading - just as you can’t expect to win every hand in poker, you can’t expect to win every trade. 

Always trade responsibly, and always be aware of how much you can afford to lose - and how much you can hope to gain.