The concept of reward to risk and the risk:reward ratio are important principles in trading, yet very few traders know how to use them correctly. The risk:reward ratio principles allow a trader to adjust and filter the trades he is about to take in a way that can give him a better expectancy. But let’s start from the beginning and explore the risk:reward ratio step by step and give you a comprehensive overview.
What is the risk:reward ratio (RRR)?
Basically, the risk:reward ratio puts the potential reward and the potential risk of a single trade into a relationship and provides you with a ratio.
For example, a trader who wants to enter a long trade on Gold with a 7 points stop and a 21 points take profit target, has a potential risk:reward ratio of 3:1 because his potential profit is three times the size of his potential loss.
The key word here is ‘potential’ and we will soon explore how traders can avoid some common and harmful problems when it comes to using the risk:reward ratio.
Avoid optimism when you get into a trade
A common mistake many traders make is that they arbitrarily pick a very distant take profit level or use a stop loss that is too tight just to create a larger risk:reward ratio. Of course, this leads to two problems and eliminates all the potential benefits the risk:reward ratio has: first, price can’t reach the overly optimistic target levels or and you give back profits and, secondly, price takes out the too conservative stop loss and then continues onto the profit level leaving you with nothing behind. In both cases, the trader has created the illusion of a potentially lucrative trade just to find out that his order manipulation cost him the trade.
Stop Loss Disclaimer: The placement of contingent orders by you or broker, or trading advisor, such as a “stop-loss” or “stop-limit” order, will not necessarily limit your losses to the intended amounts, since market conditions may make it impossible to execute such orders.
Very often, traders use the large potential ratio to reason themselves into a trade they shouldn’t be in and they take the potential large payoff as an excuse to bend their rules. Before you are about to enter a trade, pause for a few moments and make sure that (1) you have set your orders in a realistic way and (2) you are not violating your rules.
Tip: find weaknesses in your trading with the Risk:Reward Ratio
To get a better feeling for how well you choose your order levels and set your risk:reward ratio, it’s advisable to go through your past trades and compare your potential risk:reward ratio you were aiming for at your entry and the final risk:reward ratio when you closed your trade. Large discrepancies can signal problems in the way you choose trades, set orders, or manage your exits.
The risk:reward ratio threshold and positive expectancy
Another good way to use the RRR is as an entry threshold; if you know your historic winrate, you can use this information to find your required RRR. For example, a trader with a historic winrate of 60% should avoid trades with a RRR less than 1.67 because they might give him a negative expectancy. A trader with a winrate of 55% can take trades as long as they have a risk:reward ratio greater than 1.8, if he acts within the scope of his system. The table below shows you the winrate and risk:reward ratio threshold.
| Historic winrate | Required RRR |
| 40% | 2.5 |
| 50% | 2.0 |
| 55% | 1.8 |
| 60% | 1.6 |
| 70% | 1.4 |
The formula to calculate the required risk:reward ratio is: (1 / winrate)
As long as the trader only takes trades that are above this risk:reward ratio threshold, he puts himself in a much better position. Of course, he will still lose trades and losses can’t be avoided, but he can tilt the odds more in his favor from a statistical standpoint.
Adjust risk:reward ratio based on context – risk:reward ratio is not static
Another overlooked principle is that the RRR is never static and has to change on a trade to trade basis. Traders often try to use shortcuts and set fixed rules for their take profit and stop loss orders to come up with the same risk:reward ratio every time.
However, the way you place your profit and stop orders has to change based on the chart context. If price is about to run into a support area, you should consider setting your profit target ahead of the level and reduce the likelihood of price missing your target; if price is near a resistance level, you can set your stop at the other side to add another barrier between price and your stop.
Always using the same amount of points for your stop can quickly lead to problems when you don’t take support/resistance or other chart factors into context. Also, when you don’t adjust your profit target based on the price chart in front of you at that moment, you can easily make the mistake of placing the order at a strategic bad and hard to reach areas.
Thus, instead of using a fixed risk:reward ratio with fixed rules for your stop and target, work with a risk:reward ratio threshold instead and adjust your orders based on the actual price charts and the price context. The risk:reward ratio is a concept that can help traders potentially make better decisions and put the odds in their favor when the trader knows the weak spots and understands to avoid the common problems.
There is a substantial risk of loss in futures trading. Past performance is not indicative of future results.
