Risk-Reward Ratios

The risk-reward ratio compares potential profit to potential loss. It's a critical tool for evaluating whether a trade is worth taking. [DEFINITION] Risk-Reward Ratio (RRR): The ratio comparing the potential profit of a trade to its potential loss, calculated as (Target Price - Entry) ÷ (Entry - Stop Loss). [FORMULA] Risk-Reward Ratio = (Target - Entry) ÷ (Entry - Stop) ### Calculating Risk-Reward [EXAMPLE] Entry: $100 Stop: $95 (risk $5) Target: $115 (reward $15) RRR = $15 ÷ $5 = 3:1 You stand to make 3x what you're risking. ### Minimum Acceptable Ratios **General guidelines:** - Day trading: Minimum 1.5:1 - Swing trading: Minimum 2:1 - Position trading: Minimum 3:1 [KEY] Even with a 50% win rate, a 2:1 RRR is profitable: 10 trades: 5 winners × $2 = $10, 5 losers × $1 = $5 Net: +$5 (profitable despite being wrong half the time) ### Win Rate + RRR = Expectancy [FORMULA] Expectancy = (Win Rate × Average Win) - (Loss Rate × Average Loss) [EXAMPLE] Win rate: 40% Average win: $300 (3R) Average loss: $100 (1R) Expectancy = (0.40 × $300) - (0.60 × $100) = $120 - $60 = +$60 per trade Despite losing 60% of trades, each trade averages +$60. ### Tradeoff: Win Rate vs. RRR **Tight targets (high win rate, low RRR):** - Win 70% of trades - Winners: 1.5R, Losers: 1R - Expectancy: (0.70 × 1.5) - (0.30 × 1) = 0.75R per trade **Wide targets (low win rate, high RRR):** - Win 30% of trades - Winners: 5R, Losers: 1R - Expectancy: (0.30 × 5) - (0.70 × 1) = 0.80R per trade Both can work! Choose based on your psychology. [TIP] Some traders prefer being right often (tight targets). Others prefer big wins (wide targets). Know your psychological needs. ### Practical RRR Considerations **Before entering every trade, ask:** 1. Where is my stop? (Define risk) 2. What's my realistic target? (Define reward) 3. Is the RRR acceptable? 4. Does price action support reaching the target? [WARNING] Don't manipulate targets to get acceptable RRR. If the realistic target only provides 1:1, the trade isn't worth taking—find a better setup. ### R-Multiples Express all trades in terms of R (your risk unit): [EXAMPLE] You risk $200 per trade (1R). - +$600 win = +3R - +$200 win = +1R - -$200 loss = -1R - -$100 (stopped early) = -0.5R [KEY] Track your trading in R-multiples. This standardizes performance regardless of position size changes. [EXERCISE] You're considering a trade: Entry $50, Stop $48, Target $58. Calculate the RRR. If your win rate on similar setups is 45%, what's the expectancy per trade in R? |ANSWER| Risk = $50 - $48 = $2. Reward = $58 - $50 = $8. RRR = $8 ÷ $2 = 4:1. Expectancy = (0.45 × 4R) - (0.55 × 1R) = 1.8R - 0.55R = +1.25R per trade. Excellent! [SCENARIO] You find a great-looking chart pattern. Entry at $30, logical stop at $27 (risk $3). But the next resistance is at $33 (reward $3). RRR = 1:1. What do you do? Skip this trade. A 1:1 RRR requires a very high win rate to be profitable, and most patterns don't provide that. Either wait for a better entry (closer to the stop, improving RRR) or find a different trade altogether. The best traders skip more trades than they take.