Risk to Reward Ratio Explained

Being a trader is about more than just buying and selling securities in the open market, what we actually do to profit from this activity is manage our risk exposure.

We work in probabilities, the trade setups that we take will never be 100% accurate and you will realize that sometimes the best setup with all the instruments confirming the idea can go sideways because of unexpected news or some other event out of your control.

The best thing that we can do as traders is to correctly asses the risk we have to take in order to take a position in the markets and calculate the possible reward or profits that we can take out of it. This is called the risk to reward ratio. 

Generally speaking, a good trade setup should have a risk to reward ratio of 1:2 or better (i.e. target profit level of 10 points with a 5 point stop loss).

Example of Risk Reward Exposure on GOOG

Let´s take a simple example to better illustrate this. Let´s imagine we open a long spread bet on GOOG at $550 and that the correct placement of the stop loss is $10 below the entry price at $540. Let´s assume in this scenario that $1 move is one point, so our risk is 10 points in this case.

If the next area of strong resistance is at the $554 level, that is where our exit level should be placed. By taking this trade, we would be risking 10 points for a possible profit of only 4 points, making our risk to reward ratio 2.5:1. This constitutes a bad trade (negative risk to reward) even if your targets get hit.

Mathematically speaking this is a bad trade because even if we are right on our assumption that price will go up 50% of the time, we will still end up losing money in the long term; in fact we would have to be right more than 65% of the times to just break even.

Now let´s assume we take the same exact trade risking 10 points but the next level of strong resistance is at $570 and not $554. In this scenario, we will be risking 10 points for a possible profit of 20 points, making our risk to reward ratio of 1:2.

Mathematically speaking this is a great trade because even if we are correct 50% of the times we will make money in the long term.

As you can see, not all of the setups give you a 1:2 risk to reward ratio, and it´s our job to be very discriminative when it comes to deciding to make the bet or not.

Let´s go through some examples of bad trades and good trades using real charts

Good Trade Setup:

Here´s the daily GOOG chart where we found a double top around the $613 level. We are contemplating opening a short spread bet once the previous area of support at $592 is broken.

risk reward ratio

–        In this case our stop loss should be above the double top at $614

–        The area of support that need to break in order for us to get a clear entry is $591

–        This makes our risk of $23 should we decide to take the trade

–        The next step is to calculate the distance between the entry area and the next area of support at $560

–        This makes out possible profits of $31

–        The risk to reward of this trade is 1:1.31 making it an acceptable trade to take

Bad Trade Set up:

Now let´s have a look at a bad trade considering the risk to reward it implies. This is the GOOG daily chart and we are in a range bound market.

Price has tested the $460 level twice already and moved down. After the last correction we see a pin bar formed and then a big red candle giving us a signal of rejection of the $453 level.

risk reward 2

–        The entry of this trade would be when the red candle closes at $448.50

–        The correct stop level should be above the last high around the $464 level

–        This means we are risking $15.5 on this trade

–        If you look closely you can see that we have a strong ascending support (black trend line)

–        We can´t know for sure if price is going to break below it so our target should be around it

–        $444 is a previous level of support that confluences with the trend line

–        This gives our trade a possible profit of $4.50

–        The risk to reward on this trade is 3.4:1 making it a terrible trade.

As you can see, making good decisions when trading is not only taking good technical set ups but also calculating the risk of your positions against the possible return of it. We´re risk managers, and the better we do our job, the more profit we will take out of the markets.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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