Risk Vs Reward
Is it worth it? Any time you risk anything in life, not that we always do, it would be wise to ask if it’s worth it. Being able to do this with your trades will help insurmountably to become a profitable trader.
If you risk a single dollar in an attempt to gain 2 Dollars, your risk to reward ratio (RR) is 1:2. Similarly, if you Risk 1$ in an attempt to gain 3$ your risk to reward is 1:3. That is the most popular ratio. Once I’ve explained why people seek a good RR you might understand why.
See, someone very smart some time ago figured, “If I put a dollar on the line, I should get back more I risk for this bet to be worth it.” Makes sense right? Trading is Numbers. All you do is weigh up the probability of something happening and betting money on it.
As with any bet, you’re gonna lose some (probably a lot). And WHEN (not IF because no one is Rambo in the marketplace) you lose, how do you play your cards so that it doesn’t matter in the long run. This is how!
If you’re a quick maths kinda guy or gal, you’ve figured that you even if you win only 50% of your trades you still make $5000 PROFIT and that’s only a 1:2 risk to reward. At this point, you have already imagined pulling off a 1:3 RR “Woo! Call off the dogs, put out the fire! I’m ready to quit my job!” You should not be gung ho just yet. Here’s why…
In order to achieve this, you actually have to win 50% of your trades. People lose sight of that and that’s 50% consistently over a period of time. The table above shows an order of wins and losses that will almost never happen! A more likely scenario is something like this
The same outcome is achieved right? Yeah, but with a concrete will and balls made of grade 434 stainless steel! Those first 3 losers would’ve cast doubts in anyone’s mind.
But again, over a long enough period of time, you won 50% of your trades by making sure you stuck to a 1:2 risk to reward. If you at any point started risking less or more you would’ve screwed with the whole process and probably would lose money long term. Even worse, if you changed your system completely after trade 3.
What's in it for me?
The reward part is the hard part of this approach and only one side. A good risk to reward allows you to make money without being right as often. But do not get it twisted you still need to win. A 1:3 ratio could not save you if you lost 80% of your trades. Similarly, a trader who won 75% of their trades can get away with risking a dollar for a dollar.
But trust me big fella, it is WAY easier to focus your efforts on a good RR than a high win percentage. You need to know your trade. Scalpers (Very short term traders) usually count on high win percentages. Position traders (Very long term traders) usually count on high RRs.
Like a throttle, you gotta find the sweet spot and what suits your trading personality. Once you know your trade (through back-testing and demo trading) you’ll have an idea of the kind of reward you can expect.
A scalper does not need to hold 1 trade for a year because his many trades will make up for it. A position trader does not flinch from day to day market swings. But whether you’re a scalper, a position(er), a swinger (not in that way!) never cap your upside! Yes, it’s unlikely for price to forever go in your favor but leave some on in case it does. You will thank yourself.
Don’t bet the farm.
Don’t lose your shirt.
Cut the L.
Keep the W.
Risk to Reward FAQ
Risk to reward is a ratio of the your potential loss versus the potential reward. So if you risk $1 to make $3, you have a Risk to Reward of 1:3.
1:3 is a popular ratio. I suggest you try and increase that if you can to 1:4 or 1:5.
For you to determine your Risk to Reward, you need to have a profit target in mind. Once you have one, see how many times bigger your target is than your potential loss and Voila!