The Risk Reward Ratio In Trading

To the professionals, the risk reward ratio is perhaps more important than the winning rate. Not many people know you can make money by being 50% correct. However, that is exactly what some professional traders are able to do. They make money day in day out by just being correct 50% of the time.

What's their secret?

Answer: The magnificent risk reward ratio

Being Correct Only 50% Of The Time But Still Raking In Profits

One of the big secrets that the professionals know that the average trader does not know is that you can be profitable even if you are correct 50% of the time.

The risk reward ratio is the magical and powerful force that skew the results in the favor of the professional trader. The normal trader will always prefer a high win rate. 

Let me ask you a personal question. 

Which winning rate or winning percentage will you want?

  1. 95% winning rate
  2. 90% winning rate
  3. 80% winning rate
  4. 75% winning rate
  5. 65% winning rate
  6. 55% winning rate
  7. 50% winning rate
  8. 40% winning rate
  9. 30% winning rate
  10. 25% winning rate

Amateurs answer: 80% winning rate and above

Professional's answer: It depends on the risk reward ratio of the trading strategy

What would your answer be?

I think most of us would like to have as high a winning rate as possible. But the winning rate can be deceiving. A high winning rate does not guarantee that your account will grow. On the other hand a low winning rate can still make your account grow.

Scenario 1

Let's say your trading strategy has a win rate of 80%.

  • Each time you win you make $1000
  • Each time you lose you are down $1000
  • Therefore your risk is $1000
  • Your reward is $1000
  • Your risk reward ratio is 1:1
  • Out of 10 trades you will make $8000 and lose $2000, you end up with $6000

Scenario 2

Let's say your trading strategy has a win rate of 90%, which is Amazing!

But wait...

  • Each time you win you make $1000
  • Each time you lose you lose $7000
  • Therefore your risk is $7000
  • Your reward is only $1000
  • Your risk reward ratio is 7:1
  • Out of 10 trades you will make $9000 and lose $7000, you end up with $2000

Scenario 3

Let's say your trading strategy has a win rate of 60%

  • Each time you win you make $2000
  • Each time you lose you lose $1000
  • Therefore your risk is $1000
  • Your reward is $2000
  • Your risk reward ratio will be 1:2
  • Out of 10 trades you will make $12000 and lose $4000, you end up with $8000

Now that you have had a look at the 3 scenarios, I think your thoughts will be very different from when we started. 

You see my friends, it is not all about the win rate. The risk reward ratio is the one that you should look out for. Therefore, if we were to choose a trading strategy, it would be better if we choose the 3rd scenario. 

We might have more losses, but the rewards justify us to take the small losses. 

What Is The Risk Reward Ratio?

If you still do not understand the basics of the risk reward ratio, let me take a moment here to enlighten you.

  • The risk is the amount you are willing to lose in a single trade
  • The reward is the amount of money you stand to make if you are correct

You get the risk reward ratio by dividing the risk with the reward.

Each trading strategy will have their own risk reward ratio.

  • For example, trend trading strategies will tend to have limited risks but unlimited rewards
  • Range bound trading strategies will have a defined reward because of the support and resistance

It is very important that the new trader learn to choose a trading strategy that fits his or her personality. They also need to determine how much losses they can stomach and how much wins that will be able to help them take care of the losses.

What Is An Acceptable Risk Reward Ratio

Now that you realize the importance of the risk reward ratio, perhaps the next question that is on your mind is what is the minimum risk reward ratio that you should accept.

There is not direct and definitive answer.

You should be able to balance the amount of wins and losses with the risk reward ratio to come out with a trading strategy that will make your account grow steadily in the long run.

I believe the very minimum risk reward ratio that you should aim for when choosing a trading strategy is 1:1. This means that for every $1000 you risk, you stand to make $1000 if you are correct. When you have a risk reward ratio of 1:1, all you need is a win rate of 60% and above.

The very minimum risk reward ratio a trader should aim for is 1:1. A R/R of 1:2 is ideal while a R/R of 1:3 will be best

If you have a risk reward ratio of 1:2, the odds now become more and more conducive for you to grow your account. With a risk reward ratio like this you can easily breakeven with just a small win rate of around 35%. Finding a trading strategy that gives you a R/R of 1:2 and a win rate of 60% will go a long way in growing your account every week.

What if you could find a trading strategy with a R/R of 1:3?

That would be superb.

Imagine having a win rate of 60% with a risk reward ratio of 1:3. Let's say you risk $1000 per trade. Out of 10 trades, you will lose $4000 but each successful trade will net you $3000. Multiply the $3000 with 6 and you get a profit of $18000. At the end of the week you are up $14,000 and that is incredibly profitable.

Conclusion

If you have read this far, you have actually stumbled across one of the market secrets of the professional trader. The professionals are very serious when it comes to the risk reward ratio. It is so important that I recommend that you find a trading strategy that gives you a good risk reward ratio with an acceptable win rate. If you do not have a trading strategy, I recommend that you hop over to the Trading Strategies section on this website and find one that suits you.

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