What is the reward-to-risk ratio
The reward-to-risk ratio (RRR) is one of the most important metrics used by traders to assess the potential profitability and loss of a particular trade. This ratio quantifies expected returns on trades in relation to the Risk taken. Divided by the possible loss and profit, the reward-to-risk is calculated. A high ratio indicates a better trade opportunity. This article will explain that the reward-to-risk ratio is much more than just a simple calculation.
Calculating the reward-to-risk ratio
Calculating the risk-to-reward ratio is simple. If a trader evaluates a short trade idea with a current price of 15387.2, stops loss at a cost of 15565.7, and takes a profit price of 140854.6, then calculating the reward-to-risk ratio is not difficult.
You calculate the Risk. The Risk is calculated as the difference between the entry price and the stop loss.
Risk= Stop Loss-Entry price = 15565.8-15387.8= 178.0
The potential reward is calculated. The difference between the entry calculates the bonus and take profit prices.
Reward : Entry Price – Take Profit = 14854.6 – 15387.8 = 533.2
Divide the reward by the calculated Risk to get the reward/risk ratio.
Reward-to-risk ratio = Reward / Risk = 533.2 / 178.0 = 2.99 = 3
You will often see the reward-to-risk ratio displayed as 3:1, which means that the trade offers three times more premium than Risk.
The calculation for the long (buy trade) follows the same logic. You can use the Long/Short Position tool in Tradingview to automatically calculate your reward-to-risk ratio without having to do any calculations.
What does the reward-to-risk ratio tell you
Ideally, a trader should measure the reward-to-risk ratio before entering into a trade in order to assess its profitability as well as to ensure that it offers enough potential rewards. Let’s look at these two aspects in order to understand them better.
TRADE PROFITABILITY REWARD TO RISK RATIO
We can continue with our previous example of a 3:1 reward-to-risk ratio and say that if you take the same trade repeatedly with the same premises and three losses but win one business out of four, then you will break breakeven.
Trade 1 – Loss: We lost 178 points (a total loss of 178)
Trade 2 – Loss: We lost 178 points (a total loss of 356)
Trade 3 – Loss: We lost 178 points (a total loss of 534)
Trade 4 – We Win 533.2 Points
Total: +/- 0 Points
To avoid this, it is important only to take on trades with a reward-to-risk that is high enough. This also shows that traders do not need to win every business (or even the majority of them) to be successful long-term. A trader who can win 2 out of 4 works at the same reward-to-risk ratio of 3:1 will make a profit.
TRADE-REWARD POTENTIAL
Before entering trading, the trader must analyze the chart and determine if it has a high reward potential. The reward potential of a trade may be limited if, for example, the price has to pass through an important support or resistance level before it reaches the take-profit level.
The trader should identify trading opportunities in which the price doesn’t have to pass through major resistance and support barriers to reach the desired level. The higher the number of “obstacles,” the more likely the price is to bounce between the entry and the target.
The REWARD TO RISK RATIO and Your WinRate
I’ve already mentioned that the reward-to-risk ratio is related to the win rate of a trading strategy. A trader who has a reward-to-risk of 3:1 can still lose three out of four trades but still come up with a break-even result. For a 3:1 reward-to-risk ratio, this would mean the minimum win rate required to break even is 25 percent. Divide one by 4 to get the win rate of 25% (one trader for every four).
The higher the reward-to-risk ratio, the lower the win rate required to break even. Below is a table that shows the win rate required to break even for different reward-tneededatios.
The dangers of a high reward-to-risk ratio
Many traders assume that if you aim for a higher reward-to-risk ratio, then it will be easier to earn money because you don’t need a very high win rate. Although this is true theoretically, there are some caveats.
To achieve a high ratio of reward to risk, traders can either use stop-loss orders that are close to the price of entry to lower the Risk or set their target levels far from the cost of admission to boost the reward. The trader would get a better reward-to-risk ratio with either option. What does this mean to the trade? And why isn’t larger also better in terms of the reward-to-risk balance?
A broad trade means that price movement may take more time to reach the target level. The farther the target is away from the entry point, the less likely it is that the price can make it to the end. The larger the target, the lower the odds that the price will be able to reach the end. Wide targets are, therefore, harder to achieve and usually result in a lower rate.
This dynamic between reward-to-risk and take-profit is illustrated in the screenshot below. The reward-to-risk ratio is doubled by doubling the distance to the take-profit. Looking at the new outlook for the trade, it is clear that the trading time will also increase.
A close stop-loss will make it easier for the price of the trade to reach the stop-loss. More packed stop-loss orders can cause traders to lose their careers even if they are only experiencing small price changes and low volatility. The lower the rate, the closer the stop-loss order is because the price can easily reach the stop-loss.
The screenshot below shows that the distance between the stop loss and the trade has been halved, and the reward-to-risk ratio has doubled, reaching 6:1. The reward-to-risk percentage will be higher, but the price is more likely to get the stop loss.
Understanding the natural relationship between stop-loss and take-profit distances will help traders improve their Risk Management and make better decisions. Many traders do not realize how changing their stop loss and take profit orders will impact their trading performance.