Reblog: How To Use The Reward Risk Ratio Like A Professional
The reward to risk ratio (RRR, or reward:risk ratio) is maybe the most important metric in trading and a trader who understands the RRR can improve his chances of becoming profitable.
A trader who uses the RRR incorrectly will never become profitable on the other hand. In this article, I will show you what you need to know about the RRR.
Busting myths around the reward:risk ratio
Let’s first tackle some of the common misconceptions about the RRR to help you understand what most people get wrong before then diving into the specifics of the RRR.
Myth 1: The reward:risk ratio is useless
You often read that traders say the reward-risk ratio is useless which couldn’t be further from the truth. When you use the RRR in combination with other trading metrics (such as winrate), it quickly becomes one of the most powerful trading tools.
Without knowing the reward:risk ratio of a single trade, it is literally impossible to trade profitably and you’ll soon learn why.
Myth 2: Good vs. bad reward:risk ratio
How often have you heard someone talk about a generic and randomly chosen “minimum” risk reward ratio? Even popular trading books often state that trades with a reward:risk ratio of smaller than 2:1 or 3:1 have to be avoided. This is very wrong and can even lead to a decline in trading performance.
Whenever you read something like that, leave the website immediately. As we will see shortly, the optimal reward:risk only depends on YOUR own trading strategy and YOUR performance, and on nothing else.
There is nothing like good or bad reward:risk ratios.
Myth 3: Don’t justify bad trades with large reward-risk ratios
Often, traders think that by using a wider take profit or a closer stop loss they can easily increase their reward:risk ratio and, therefore, increase the expectancy of their trading performance. Unfortunately, it’s not as easy as that.
Using a wider take profit order means that price won’t be able to reach the take profit order as easily and you will most likely see a decline in your winrate. On the other hand, setting your stop closer will increase the amount of premature stop runs and you will be kicked out of your trades too early.
Amateur traders often justify “bad” trades where they are not trading within their system with a larger reward:risk ratio. Your trading rules are there for a reason and a bad trade does not suddenly become acceptable by randomly hoping to achieve a larger
Your trading rules are there for a reason and a bad trade does not suddenly become acceptable by randomly hoping to achieve a larger reward:risk ratio.
The basics – reward:risk ratio 101
Basically, the reward:risk ratio measures the distance from your entry to your stop loss and your take profit order and then compares the two distances (the video below shows that).
Step 1: calculating the RRR
Let’s say the distance between your entry and stop loss is 50 points and the distance between the entry and your take profit is 100 points, then the reward:risk ratio is 2:1 because 100/2 = 2.
Step 2: Minimum Winrate
When you know the reward:risk ratio for your trade, you can easily calculate the required winrate (see formula below). You can quickly see whether the
You can quickly see whether the reward:risk ratio is large enough for your historical winrate or if you should skip that trade when the reward:risk ratio is too small.
Why is this important? Because if you take trades that have a small RRR you will lose money over the long term, even if you think you find good trades. The trade always has to offer a large enough RRR for your historic winrate:
Minimum Winrate = 1 / (1 + Reward:Risk)
Required Reward:Risk Ratio = (1 / Winrate) – 1
Example 1: If you enter a trade with a 1:1 reward:risk ratio, your overall winrate has to be higher than 50% to be a profitable trader:
1 / (1+1) = 0.5 = 50%
Example 2: If your system has a historical winrate of 60%, you need a reward:risk ratio of 0.6 : 1 to achieve a long-term expectancy:
(1 / 0.6) – 1 = 0.7
Cheat Sheet for reward:risk ratio and winrate
|Your historical winrate||Minimum reward:risk ratio|
|25%||3 : 1|
|33%||2 : 1|
|40%||1.5 : 1|
|50%||1 : 1|
|60%||0.7 : 1|
|75%||0.3 : 1|
Tradeciety’s reward:risk calculator – Our math guide
Traders who understand this connection can quickly see that you neither need an extremely high winrate nor a large reward:risk ratio to make money as a trader. As long as your reward:risk ratio and your historical winrate match, your trading will provide a positive expectancy.
Profitable or losing strategy?
Now let’s take a look at some performance statistics and how the RRR fits in.
Below, we see a performance simulation in our edgewonk trading journal based off a strategy with a winrate of 50% and a risk of 2.5% per trade. The RRR was set to 2:1 on average per trade.
You can see tha our of those 20 simulated outcomes (the different graphs), all of them were positive after 500 trades. Remember, with a wirnate of 50%, you just need a RRR higher than 1:1 to trade profitably.
Now let’s take a look at the same strategy with the same risk per trade and the same winrate. The only thing I changed was the RRR and now each trade has a RRR of 1:1.
You can see that out of the 20 simulated outcomes, only a few generated a positive outcome and many showed a negative outcome.
With a winrate of 50%, trading a RRR of 1:1 is very volatile and varience will be huge. Making money then becomes a gamble, whereas in the example above it is much more planable and certain.
In my own trading, I use a RRR threshhold of 2:1 and whenever I find a setup that doesn’t offer me a RRR that is larger than 2:1, I will skip the trade – no matter how good the setup might look like.
Of course, you could hit a lucky streak and end up making some money with a small RRR but over the long-term the statistics will always play out and you will have bad results with a small RRR.
Extra: Professional traders about reward:risk ratio
“You should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.” – Paul Tudor Jones
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros
“Frankly, I don’t see markets; I see risks, rewards, and money.” – Larry Hite
“It is essential to wait for trades with a good risk / reward ratio. Patience is a virtue for a trader.” – Alexander Elder
“Paul Tudor Jones [had a principle he used to use] called 5:1. […] he knows he’s going to be wrong [sometimes] so if he loses a dollar and has to spend another dollar, spending two to make five, he’s still up $3. He can be wrong four out of five times and still be in great shape.” – Anthony Robbins on Paul Tudor Jones
“The most important thing is money management, money management, money management. Anybody who is successful will tell you the same thing.” – Marty Schwartz
The original article is written by Rolf, appears on tradeceity.com and is available here.