On the surface, risk vs. reward seems simple.
Just make sure you have a three to one risk/reward ratio and – hey presto – you can go back to searching for that perfect entry.
But like so many trading concepts, what seems simple has a lot of depth, with plenty of room for mistakes and great opportunity.
A superficial understanding of risk/reward just won’t do it justice. We need to look closer to ensure our trading can be as good as it can be.
The basics: risk/reward ratios
Knowing the risk/reward ratio of your trades should be one of your bread and butter trading activities.
What is your potential loss compared to your potential gain?
For example, some traders like Paul Tudor Jones look to make five times their risk on the trade, which gives a risk/reward ratio of 1:5. Others might look to make an amount equal to their risk, giving them a risk reward profile of 1:1.
The point is not necessarily to pick one or the other – that comes later, when you set your trading system’s objectives – but to make sure you know the risk/reward of the trade you are about to place.
An unhealthy obsession
There tends to be an unhealthy obsession amongst some traders with having a high risk/reward ratio (1:3 is a common one), which leads to some not so helpful trading behaviour at times.
For example, it’s no good sticking a profit target three times the distance of your stop away and simply hoping that is enough to make your trading system profitable.
Instead, the risk/reward profile of the trade should be carefully considered based on the opportunity presented in front of you, and how you implement the trade to produce the best outcome.
The problem with focusing on a simplistic view of risk reward (like all trades must have a 1:3 ratio), is that it leads to the trader doing things backwards.
The cart before the horse
Some traders will place a tight stop-loss just so they can have a suitable risk reward ratio, but this is putting the cart before the horse.
Tightening the stop to manufacture a superior risk/reward ratio does not work. You simply can’t turn a poor opportunity into a good one by moving the stop closer to the entry.
In fact, if you think about it logically, it makes sense to have the stop further away on a lower quality trade as a tight stop is highly likely to be triggered.
Instead, wait for an opportunity with a naturally high risk/reward profile and then place your stop where it is most likely to achieve your trading system’s objectives.
(For students of Van Tharp – this is what he means when he talks about having a 1:3 risk/reward ratio. Finding opportunities that have a favourable risk/reward profile, rather than manufacturing them)
Risk/reward vs. win rate
Setting your system’s risk/reward profile is a balance between consistency (win rate) and profitability (risk/reward)
A system that makes less profit but is easier to trade because it wins more often can be a better choice for traders over a more aggressive trading system with bigger wins and more losses.
To alter the risk/reward ratio, you could stalk an entry point on a lower timeframe, which will improve the payoff and lower the risk. Conversely, you could widen the stop-loss, which will decrease the reward, but increase the win rate.
Neither of these things will turn a good opportunity into a bad one or vice versa.
They are just going to allow the trader to meet different objectives, whether the aim is to create an easier system that wins more often therefore is easier to trade, or a more profitable trading system with larger winners (that could be difficult to trade).
Ways of calculating your risk/reward
Another area where an overly simplistic view of risk/reward falls down is assessing the risk/reward profile of a trading system.
There are three measures of risk/reward that should be considered:
- Targeted risk/reward
- Current risk/reward
- Effective risk/reward
Targeted risk/reward is what we commonly refer to as the risk/reward ratio. It is based on the risk/reward profile of the trade prior to entry. For example, if you are looking to make 3 units for every one unit you risk, then your targeted risk/reward ratio is 1:3.
The current risk/reward is the live risk/reward profile of your trade as it changes throughout the lifecycle of your position. For example, you might start with a targeted ratio of 1:2, and then move stops, take profits, or add to the trade as part of your trade management rules. The trade’s current risk/reward profile will be drastically altered while it is live in the market.
A trade that improves the risk/reward ratio is superior to one that keeps it static.
The effective risk/reward ratio is your ending risk/reward profile across a number of trades. For example, your average winner might be three times larger than your average loss.
In this case, you might have a targeted risk/reward of 1:2. If your average loss is 0.3 and average win is 0.9, you would divide your average win by your average loss to reveal an effective risk/reward of 1:3 – substantially better than it seemed on the surface.
Of course, you might have the reverse. A system that targets 1:3 could end up with an effective risk reward of 1:1.5 or worse.
It gets interesting when you start to run comparisons with win rates factored in. For example, would you rather have a trading strategy that makes on average 0.9 and loses on average 0.3 (for an effective risk/reward of 1:3) with a 60% win rate, or a system with a targeted risk/reward of 1:3 and a 40% win rate?
Without a detailed knowledge of risk/reward, many traders would choose the system with the 1:3 targeted risk/reward and 40% win rate. But if you grasp the concept of effective risk/reward analysis, you might find the system that makes 0.9 just suits you better. It would be easier to trade, and is of higher quality allowing you to trade it at a larger size.
Consider your risk/reward holistically
There are several strategies that may superficially seem like they don’t make sense from a risk/reward point of view, but they serve crucial roles in a consistent trading system.
Generally, these form part of your implementation plan for the trade.
For example, you might have part of the trade that you take off quickly to keep the win rate high, minimize losses, trade what’s in front of you, and safeguard your psychology. Or you might take a small position at market, so you can profit in case your buy the dip entry is not hit.
When looking at the risk/reward profile of the trade, you need to consider the whole trade including all its component entries and exits, instead of just one individual part.
Every trade you put on should be structured to provide you with the most favourable risk/reward profile for the current circumstances overall. Looking at single parts in isolation might mean you miss seeing the forest for the trees.
How about you?
What risk/reward ratio do you think is acceptable on your trades? How do you structure the risk reward profile on your trades?
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is the owner of www.fxrenew.com. If you like Sam’s writing you can subscribe to his newsletter.