Risk-Reward Ratio: Your Essential Trading Technique

Defining the Risk-Reward Ratio

One of the most crucial indicators that traders use to assess a trade’s potential profitability versus its possible loss is the reward-to-risk ratio, or RRR. This ratio, in essence, measures the predicted return on a deal relative to the amount of risk assumed. The reward-to-risk ratio, which is determined by dividing the possible profit by the potential loss, indicates a more advantageous trading opportunity when it is high and indicates the reverse when it is low. However, as we shall see in this piece, there is a lot more to the reward-to-risk ratio.

Risk-Reward Ratio Calculation

It is quite simple to calculate the reward-to-risk ratio if a trader is assessing a possible short trade idea with a current entry price of 15387.8, a stop loss of 15565.8, and a take profit price of 14854.6. You determine the risk first. The gap between the entry price and the stop loss represents the risk:

Risk is equal to Entry price – Stop Loss, or 15565.8 – 15387.8 = 178.0.

You then determine the trade’s possible profit. The difference between the entry price and the take-profit is the reward.

Reward: 15387.8 – 14854.6 = 533.2 is the entry price minus take profit.

Divide the benefit by the risk that we just computed to obtain the reward-to-risk ratio:

Reward / Risk = 533.2 / 178.0 = 2.99 = 3 is the reward-to-risk ratio.

The reward-to-risk ratio is frequently shown as 3:1, meaning that there is three times the reward for every risk involved in the trade.

What The Risk-Reward Ratio Indicates

Before making a transaction, a trader calculates the reward-to-risk ratio to assess the trade’s profitability and confirm that there is sufficient reward potential. To have a better understanding of those two features, let’s discuss them.

Return on Investment and Profitability of Trades

Using the 3:1 reward-to-risk ratio and our earlier trade example, we can conclude that, if we consistently make the same transaction with the same assumptions, we can realize three lost deals and still break even if we can win one out of every four trades:

Trade 1: Loss: 178 points lost (lost 178 in total).

Trade 2: Loss: 178 points lost (lost 356 in total).

Trade 3: Loss: 178 points lost (loss of 534 total).

Trade 4 Win: 533.2 points were gained.

Total: – 0 points.

As a result, it is crucial to enter deals with a high enough risk-reward ratio. It also emphasizes that a trader can profit over the long run without having to win every trade—or even most of them. A trader will complete the day with a profit if, with the same 3:1 risk-reward ratio, they can win two of every four deals.

Reward Rate

There is a relationship between a trading system’s win rate and its reward-to-risk ratio. A trader who has a 3:1 ratio can lose three of every four deals and yet break even and not lose money. This would imply that the minimal win rate needed to achieve a break-even threshold at a 3:1 reward-to-risk ratio is 25%. By dividing 1 by 4 (one winner for every four deals), we obtain the 25% win rate.

The needed win rate to break even will decrease with an increasing reward-to-risk ratio. The necessary win rate to reach the break-even threshold for various reward-to-risk ratio sizes is displayed in the table below.

Hazard Associated with a High Reward-Risk Ratio

Now, a lot of traders may think that since you don’t need a high win rate, it should be simpler to earn money if you strive for a high reward-to-risk ratio. There are certain restrictions even if this is true in theory.

To get a high risk-reward ratio, a trader may either employ stop loss orders that are extremely near to the entry price to lower the risk associated with the trade or place their target levels far away from the entry price to maximize the reward of the trade. The trader would benefit from a stronger reward-to-risk ratio from both.

A broad trade objective indicates that it will take longer for the price movement to go toward the desired level. Furthermore, there is less chance that the price will be able to go all the way to the target the further it is from the entrance. The likelihood of the price attaining the entire winner decreases with increasing goal width. Therefore, wide targets are more difficult to hit and usually have a lower potential win rate.

The relationship between the take-profit and the risk-reward ratio is seen in the screenshot below. This raises the reward-to-risk ratio to 6:1 by increasing the take-profit distance.