What Is Risk to Reward Ratio?
The risk to reward ratio signifies the prospective reward an investor/trader could earn for each dollar he/she risks on an investment/trade.
Most investors use risk to reward ratios to relate the expected returns of an investment with the amount of risk needed for them to undertake so as to earn these returns.
For instance, any investment with a risk to reward ratio of 1:4 suggests that an investor is okay with risking $1, for the purpose of earning $4.
On the other hand, a risk reward ratio of 1:2 signals that an investor should look forward to investing $1 to gain $2 on his/her investment.
By virtue of trading in the stock and forex market, it means that you are a risk-taker. As an individual trader in the market, there are few safety tools you have at your disposal, like the risk to reward calculator.
The exact calculation to know the risk vs reward when taking any trade is so simple. You simply divide your net profit (the reward) by the price of your maximum risk.
Unfortunately, retail traders end up losing a lot of the money that they have deposited with their preferred forex brokers.
There are numerous reasons for this, but one of those comes from the fact that most retail traders don’t have the ability to manage risk.
Risk management is a very important aspect when it comes to forex trading. It determines whether you are going to become a long-term profitable forex trader or not.
Without risk management, you can easily blow your trading account within a short period of time (even within hours or minutes) depending on the volatility of the market.
Also Read: ATR Indicator (Average True Range): Best Indicator
How to Calculate Risk to Reward Ratio
The risk to reward ratio formula is quite straightforward.
If you risk 40 pips on a trade and you plan a profit target of 120 pips, then your effective risk to reward ratio for that trade would be 1:3.
=divide your net profit (the reward)/the price of your maximum risk
Additionally, while trading, you should also consider the spread being charged by your forex broker to carry out the risk and reward analysis accurately.
If you ignore the spread, you will end up using a risk/reward ratio for your trades that is not really correct.
For instance, in case you are a scalper who likes risking a maximum of say 4 pips in each trade and purpose to gain around 10 pips from every trade, do you really think you are getting a risk/reward ratio of 1:2? NO!
In case your broker is charging 2 pips spread on, let’s say USDCHF, then in your case, you will be (4 + 2 )= 6 pips to get (10 – 2 )= 8 pips for your profit target.
This means that your net risk reward ratio is 1: 1.133, not 1:2, which you wrongly considered as you failed to account for the transaction costs.
You do not have to be a math wizard to know that it would require a much higher win rate to compensate for this huge risk to reward ratio difference because of spreads based on how you are executing your trades.
As the impact of spreads is tough for scalpers and day traders, this impact mainly gets easier for swing traders and position traders who mainly trade on higher timeframes.
This is one of the big differences on day traders vs swing traders.
Most retail traders, when trading on lower time frames, tend to struggle with risk management. It gets worse when they don’t take the inherent spread into account; hence end up being stopped out a lot, then the market moves in their predicted direction.
There is a time a beginner in forex trading told me that “I think ‘these people’ always know where my stop loss is. As soon as my stop-loss is hit, the trade moves in my predicted direction.”
I did not laugh at this since that logic had crossed my mind as I commenced forex trading journey. But I came to realize with time that my risk management practices were poor; hence I ended up placing my stop loss at undesirable zones/areas.
There are millions of traders out there, how and why would the market makers have an eye on your trades as an individual?
It is more of a psychological aspect that there is that particular zone (a zone which is not safe) where many traders are likely to put their stop orders.
Don’t end up placing a tight stop loss so that you have a ‘desirable’ risk to reward ratio. You should always have a trading plan that guides you on the types of trades that you ought to be taking.
If a trade does not meet the criteria of your trading plan, just leave it and move onto the next one.
Risk Reward Ratio Myths
1. The risk/reward ratio is useless
Probably you might have come across an article or video saying that risk to reward ratio is not worth it.
Okay, this couldn’t be further from the truth.
However, when you use the RRR coupled with other trading metrics like the win rate, it quickly becomes one of the most powerful trading tools.
Without knowing the reward risk ratio of your trades, it is hard to trade profitably, and you’ll soon understand why as you advance in your trading endeavors.
2.“Good” vs. “bad” reward/risk ratio
How many times do you notice people talk about a generic and arbitrarily chosen “minimum” risk to reward ratio?
Even common trading books frequently note that you need at least an RRR of 1:2 or higher, mainly without even knowing any other trading limits.
Good or bad reward risk ratios do not exist. It is simply about how you use it. You can even trade profitably with a risk/reward ratio of 1:1.
If your trading strategy has a win rate of let’s say above 80%, that means that at a RRR of 1:1, you will still be profitable.
There are traders who try to force a risk reward ratio of above 1:2 and end up being stopped out most of the time due to tight stop loss.
3. A bad trade does not become better with a high RRR
Mainly, traders think that by using a wider take profit or a tight stop loss, they can simply increase their reward risk ratio and, thus improving their trading performance.
Unfortunately, it’s not that easy.
Using a wider take profit order means that price might not reach the take profit order easily, and you will probably have a reduced win rate.
Also, setting your stop closer will increase premature stop runs, and you will be removed from your trades very early.
This is a habit that affects many beginner forex traders.
Always follow your trading plan. It exists for a purpose, and a bad trade does not abruptly become acceptable by randomly wishing and hoping to get a larger risk reward ratio.
Above is an example of risk to reward ratio generated from Tradingview. The R/R is 1:2.78. Trading view is a favorable platform to undertake your analysis and establish your RRR before executing your trade.
You can check it out.
What is a Good Risk to Reward Ratio?
A high risk to reward ratio means that you don’t have to be right at all times to make money trading.
For example, if we take 100 trades, each with an RRR of 1:1, a winning rate of 50%, we shall have 50 winners and 50 losers.
From this, you would end up around break-even since the loss per trade is the same as the profit from each trade.
Looking at a second example, where the trades have a risk to reward ratio of 2, it means that the average winning trade is double the average loss.
Here, you will gain profit even with a 50% winning rate, as the winning trades would be in plenty to fill in for the losing trades.
However, this does not mean that you should try to fix all your trades so that you can get an RRR of 1:2 and above. This is more to the beginners in forex trading.
If right now, you are comfortable with a risk/reward ratio of 1:1, continue with that as your win rate is probably high.
With time, as your trading confidence increases, you will learn how to better time your entries hence getting an risk reward ratio of 1:2 and above.
Remember, if you are able to break-even for some time, you can easily now turn into a profitable trader.
Always stick to your trading plan even as you implement the risk to reward ratio proponents.