Risk-Reward Ratio (RR)
What is a good risk-reward ratio?
A high R/R ratio means that we don’t need to be right all the time to make money trading. For instance, if we take 100 trades, all having a Risk Reward Ratio of 1, with a winning rate of 50%, there will be 50 winners and 50 losers. In this example, you would end up around breakeven as the loss per trade equals the profit per trade.
If we take another example where the trades have an R/R ratio of 2, it means that the average winning trade is two times its average loss. In this case, you will end profitable even with a 50% winning rate, as the winning trades would be more than enough to cover for the losing trades.
Some research from major brokers indicates that profitable traders tend to incorporate a risk reward ratio of higher than 1.
According to that research, traders who used a R/R ratio more than 1 had three times more chances of attaining a profit, as compared to traders using an R/R of less than 1. 53 % of the traders were profitable in the first group while only 17% of profitable traders belonged to the second group.
It should be remembered that stop-loss orders play a key role when setting up the reward-to-risk ratio. The research suggests that traders should maintain an R/R ratio of at least one in all the trades. For trade setups that do not return the desired reward to risk level, you can simply dismiss it.
Risk of enforcing an arbitrarily high Reward-Risk Ratio
Just enforcing a very large risk-reward ratio is not good as my own experience shows that it appears to be an inverse relationship between the profitability ratio and risk-reward ratio, this means that the higher the risk-reward ratio the lower the profitability ratio. This makes sense as to have a high-risk reward ratio means that your stop loss order will be much closer to your entry price than your take profit price, and that means that normal volatility can easier get you stopped out.
As an example, if your entry is 1.30, take profit is at 1.31, and your stop loss is at 1.2970, then the price is just 30 pips away from your stop loss level, and 100 pips away from your take profit. The risk-reward ratio will be a good 3.33, but the likelihood that the price will reach your stop level before reaching your take profit is higher.
In situations where volatility is higher such as day trading or scalping it is normal to see traders have inverse risk-reward ratios, on the other hand, they tend to be right more than 50% of the time. In the case of position and swing traders that usually hold positions for a few days, they tend to easier acquire higher risk-reward ratios.
How to establish a good RR
Backtesting is needed to draw up a table with three dimensions: [ => maybe a code ]
— success rate of the strategy ( >= 57 % )
— coefficient of volatility (relative volatility)
The table (or the program) would give as result the proper ratio-reward.
Intraday Trading Risk-Reward Ratio ( ITD RR)
Target for 1% every trade with RR of 1:1 and have a signalling system that is 57% correct.
[ we cannot easily get a 2% move every time for 1% risk. Volatility issues. ]
Swing/Position Trading Risk-Reward Ratio ( ST RR )
We should aim for 1:2, 1:3 even more
Articles / References
Investopedia: Risk Management [ here ]
Baby Pips: What is risk management [ here ]
Baby Pips: Risk Management in Forex [ here ]