Risk to reward ratio. The ratio many successful intra-day traders use. An amateur trader finds it difficult to understand even though its simple. Once learned can make you succeed in trading even if you are wrong majority of the time. What is risk to reward ratio? Its basically comes down how much you risk to how much your reward is. So if a trader asks another trader what’s your risk to reward he would probably say 1:3. 1 is the risk and 3 is the reward.So if your risk to reward ratio (is 1:1) then you will be risking $1 for a reward of $1. Say if the ratio is 1:2. You will be risking $1 for a reward of $2.
Lets make it simple. Imagine you and your buddy are going to gamble over a coin toss. Both you and your friend know the probability of coin toss is 50%. 50% for heads and 50% for tails. If I win heads I get $1 and if he gets tails he wins $1 as well. Now here is the problem, you can have 10 coin tosses but you wont get an exact 5 heads and 5 tails. It could well be 7 tails and 3 heads at which point you would loose 7$ from the tails and gain $3 from the heads thus netting a loss of $4.
As you can see here even if the probability of a coin is 50% its still doesn’t give you an edge. What people don’t think about is even the coin toss is 50% probability its only when we approach infinite amounts of coin tosses the numbers will equal out.
This is where the Risk to reward ratio comes in. Lets take the same example of the coin toss and instead of risk to reward of 1:1 lets tweak it a bit. Lets make it 1:3. $3 gain if it’s a head and $1 loss if it’s a tail. Assume the same result 7 tails and 3 heads. Now here is the profit calculation. You will loose $7 from the 7 tails (7 x $1) but make $9(3 x $3) from the 3 heads. The net result being a profit for $9-$7= $3. This is beauty of risk to reward ratio.
As you can see even by being wrong 70% of the time (7 tails and 3 heads) you still make money. Thanks to the risk to reward ratio of 1:3. However if the risk to reward ratio was 1:1 as seen in first example you would have had a loss.
The same thing goes with the market. The market has only 2 directions, up and down. If I enter a trade there are only two things the market can do, go in the direction of your position or against it. Having a good risk to reward ratio helps you tremendously to succeed. You don’t need to be right all the time. As you can see if you’re having 1:3 you can be wrong 70% of time and still profit.
One of the earliest mistake traders make including myself was not mastering this concept. It’s easy to come up with trading strategies with 1:1 ratio or less but eventually it’s very difficult to succeed, as your account balance will be volatile throughout which affects you psychologically and financially. You will be be happy when couple of trades goes your way but you’ll always meet a loosing streak of 6 or 7 trades which will not only stress you out but worst case scenario wipe your account especially if you’re trading in futures or margin accounts.
The advantage of a R/R ratio of 1:2 or 1:3 is that it gives you huge margin of error and also lots of breathing room both financially and psychologically. Now I’m not saying it has to be perfect 1:3 or 1:2 but it should be better than 1:1. I have had trades where my risk to reward 1:8. For those kind of rewards you should be capable to run your profits which we will discuss in a different article. I know even I have a loosing streak for a few days all I need is a couple of good trades to not only get it all back but to be on the positive side. Helps me sleep better at night.
The biggest takeaway from this article is that when you come up with trading strategies keep a close idea on what your risk to reward ratio is. Is it better than 1:1. If it’s not then dump it. There’s no reason for that strategy to be there. I have been able to substantially improve my trading by removing strategies that’s not better than 1:2. Ideally I always aim for 1:3 trading strategies. Make the math work for you ass well.
Tweak your strategies to come up with the good risk to reward ratio. Another thing that I have noted is that the number of trades that you make also substantially decreases. But who cares, if there’s anything positive from that is that you pay lower commissions. Your number of trades might go down but your profits will be on the upside.
I came across a video on Youtube about the cheetah and the antelope. The psychology of cheetah is what we need and what I see in the risk to reward ratio. The cheetah is the fastest animal in the world. It can outrun any animal out there. But the cheetah does not go after any antelope. It observes the group of antelope’s patiently for hours. Analyzing each one. Why? The cheetah doesn’t go after any antelope, it goes for the weakest antelope. It’s searching for the weak one. The cheetah knows it’s easier to catch the weak antelope than the stronger one. See what general people don’t know is that cheetah burns lots of calories in one single attempt. It can’t afford to have 3 or 4 attempts to catch the prey especially if the prey is strong. It will die of starvation.
So by choosing the weakest antelope he not only has a good probability of success but if he realizes its not going to work he can back off to save energy and wait patiently for the next weak antelope. He has got a good risk to reward ratio by doing that. Master risk to reward and you’ve mastered trading and you will make a lot of money.