The Risk/Reward Calculation
Divide the amount of money you stand to lose if the trade is unsuccessful (risk) by the amount of money you stand to win if the trade is successful (reward).
For example, let’s say a trader is thinking about buying the GBPUSD pair. Based upon where he wants to place his stop loss he stands to lose $50 if the trade doesn’t work out. That is the potential risk. And let’s say based upon where he wants to place his take profit he stands to win $150 if the trade does work out. That is the potential reward.
The trader is willing to risk $50 for a possible $150 reward; that is a 50:150 or 1:3 risk/reward ratio.
Here are some other examples of risk/ reward ratios:
- If you risk $100 for a possible $200 reward; that is a 100:200 or 1:2 risk reward
- If you risk $200 for a possible $800 reward; that is a 200:800 or 1:4 risk reward
What is an Acceptable Risk/Reward?
Most traders consider 1:2 (risking 1 to make 2) as the minimum risk/reward ratio. The preference is 1:3 or higher. The thinking is if you are going to take the risk, the amount of money you stand to gain should be substantial. On the surface, losing small and winning big sounds like a solid strategy. Traders are also quick to point out that you could win less than half your trades and still make a good profit using 1:3 or higher risk/reward ratios.
The Shortcoming of Risk/Reward
The risk/reward does not address the probability of the trade being successful. If the risk/reward ratio is 1:3 it means the price has to travel three times as far for the trade to be successful.
So the fact that the profit is three times as great as the loss is to make up for the fact it’s three times less likely to happen. And the loss is only a third of the profit because it is three times more likely to happen.
For example, let’s assume the trader buying the GBPUSD pair is trading 1 mini-lot and is risking $50 (50 points) to try and make $150 profit (150 points). That is a 1:3 risk reward. This is how it would look on the chart at the time the trade was entered into:
GBPUSD Daily Chart August 7, 2014
How to Properly Use Risk/Reward
In the above GBPUSD example the risk was 50 points ($50) and the profit target was 150 points ($150). The probability is you will win one out of four and that amounts to a breakeven result:
- 1 win of $150
- 3 loses of $50 = loss of $150
- That’s breakeven
- No advantage there
The advantage comes when you think (based upon your analysis and experience) that a trade with a 1:3 risk reward has better than a 1 in 3 chance of success. When that is the case you are getting a better payoff than you think you should get. And that represents a speculative edge.
For example, if you thought the GBPUSD buy trade had a 1 in 2 chance of increasing 150 points (profit target) before decreasing 50 points (stop loss); you would have a speculative edge because if you win the trade you will be paid off at the 1 in 3 chances rate ( $150 profit for a $50 risk).
That in essence is at the heart of all trading; an actionable opinion of payoff versus probability.
Divide the amount of money you stand to lose if the trade is unsuccessful (risk) by the amount of money you stand to win if the trade is successful (reward).
For example, let’s say a trader is thinking about buying the GBPUSD pair. Based upon where he wants to place his stop loss he stands to lose $50 if the trade doesn’t work out. That is the potential risk. And let’s say based upon where he wants to place his take profit he stands to win $150 if the trade does work out. That is the potential reward.
The trader is willing to risk $50 for a possible $150 reward; that is a 50:150 or 1:3 risk/reward ratio.
Here are some other examples of risk/ reward ratios:
- If you risk $100 for a possible $200 reward; that is a 100:200 or 1:2 risk reward
- If you risk $200 for a possible $800 reward; that is a 200:800 or 1:4 risk reward
What is an Acceptable Risk/Reward?
Most traders consider 1:2 (risking 1 to make 2) as the minimum risk/reward ratio. The preference is 1:3 or higher. The thinking is if you are going to take the risk, the amount of money you stand to gain should be substantial. On the surface, losing small and winning big sounds like a solid strategy. Traders are also quick to point out that you could win less than half your trades and still make a good profit using 1:3 or higher risk/reward ratios.
The Shortcoming of Risk/Reward
The risk/reward does not address the probability of the trade being successful. If the risk/reward ratio is 1:3 it means the price has to travel three times as far for the trade to be successful.
So the fact that the profit is three times as great as the loss is to make up for the fact it’s three times less likely to happen. And the loss is only a third of the profit because it is three times more likely to happen.
For example, let’s assume the trader buying the GBPUSD pair is trading 1 mini-lot and is risking $50 (50 points) to try and make $150 profit (150 points). That is a 1:3 risk reward. This is how it would look on the chart at the time the trade was entered into:
GBPUSD Daily Chart August 7, 2014
How to Properly Use Risk/Reward
In the above GBPUSD example the risk was 50 points ($50) and the profit target was 150 points ($150). The probability is you will win one out of four and that amounts to a breakeven result:
- 1 win of $150
- 3 loses of $50 = loss of $150
- That’s breakeven
- No advantage there
The advantage comes when you think (based upon your analysis and experience) that a trade with a 1:3 risk reward has better than a 1 in 3 chance of success. When that is the case you are getting a better payoff than you think you should get. And that represents a speculative edge.
For example, if you thought the GBPUSD buy trade had a 1 in 2 chance of increasing 150 points (profit target) before decreasing 50 points (stop loss); you would have a speculative edge because if you win the trade you will be paid off at the 1 in 3 chances rate ( $150 profit for a $50 risk).
That in essence is at the heart of all trading; an actionable opinion of payoff versus probability.
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