In today’s episode, you’ll discover the ugly truth about risk to reward ratio (95% of traders get this wrong).
So tune in right now…
Hey, hey, what’s up my friend? In today’s episode, I want to share with you the ugly truth about risk to reward ratio.
I’m sure you’ve seen many traders say that you need a minimum of a 1:2 risk-reward ratio to be a profitable trader, or if you can get 1:5, it’s even better. But to me, that’s trash. Why is that? Because your risk to reward ratio is somewhat misguided. Let me explain why.
High risk to reward ratio is not everything
Let’s say you have a trading strategy with a minimum of 1:10 risk-reward ratio. Well, since many traders want a 1:10 risk-reward ratio, we know that must be a hell of a good trading strategy.
But I forgot to mention that this strategy only wins 5% of the time, meaning 95% of the time when you trade this strategy you lose. Let’s do some simple math. Let’s say you do 100 trades, you risk $1 on each trade and you win 5% of the time with a 1:10 risk-reward ratio.
This means that each time you win, you win $10. And out of 100 trades, you win 5 times. That’s a total gain of $50. Now, what about your losses? Since you lose 95% of the time and you lose $1 per trade, your total losses are $95.
If you take $50 minus $95, what is your outcome? Well, you’re still down, you’re in the red with a -$45.
On the other hand, let’s say you have another trading strategy with a 1:0.7 risk-reward, which means that you risk $1 only to make $0.70 (it’s not even a 1:1 risk-reward ratio).
However, your winning rate is 70%. Again, let’s say you take 100 trades and you risk $1 per trade, what’s the outcome? $0.70 multiply by the 70% winning rate, you get about $49 as your total profits.
Since you lose 30% of the time at $1 each time, your total losses are $30. With $49 minus $30, you have a net gain of $19. And this using a strategy with a very poor risk to reward ratio of less than 1:1.
What am I getting at with these examples? It’s very simple. Your risk to reward ratio on its own is meaningless. Risk to reward ratio only makes sense when combined with your winning rate to have a positive expectancy.
That determines whether you’ll make money in the long run or not. Don’t get too caught up with the risk to reward ratio, thinking it’s your answer to everything because it’s not. It’s just one part of the equation.
Now the question is, how then do we use risk to reward ratio in our trading? Let me share with you a few tips.
How to find out whether the potential risk-reward on a trade is worth it (or not)
When you measure your risk-reward ratio, it’s always measured in terms of potential. For example, you can potentially risk $5 to make $10. There’s a potential of risking $1 to make $2. It’s always in terms of potential, never in terms of certainties.
Let’s say you’ve identified a trade which allows you to potentially risk $1 to make $2, you want to ask yourself this very important question, “How likely is that trade going to hit my target?”
Because you can have a 1:2 risk-reward ratio, but if there’s only a 10% chance of reaching your target then that’s not the trade you want to take. That’s how you use your risk-reward ratio to help assess whether it’s a trade you want to take on.
Now, how do you assess how likely the price is going to hit your profit target? I’ll explain.
1. Use a trading journal to assess the winning rate of your trade
Firstly, based on your journaling, you can see historically every time you take that trading setup, what is the winning rate? If your winning rate for that particular setup is 55% and your potential risk-reward is 1:2, then that’s a trade that you want to take consistently.
2. Understand the context of the market to assess the winning rate of a setup
Another way to look at it is to look at the context of the market. Let’s say this is a trade that potentially has a 1:2 risk-reward ratio, then how likely is the price going to reach your target?
Let’s say you don’t have your stats with you, then you want to ask yourself questions like, “What is the trend? Am I trading in the direction of the trend or against it?”
Because if you are trading in the direction of the trend, there is a high chance that the market will hit your target profit and you’ll achieve that 1:2 risk-reward ratio.
At the same time, you also can look at the price structure for other obstacles in your trade. Let’s say you buy at support with a 100 pips stop loss and your target profit is 200 pips away. Ask yourself, “How likely is the price going to reach that target of 200 pips?”
If the price has to break through two levels of resistance and you’re trading against the downtrend, then you can be sure that trade is unlikely going to hit your target. Not impossible, but unlikely.
This is how you can use the market structure to decide on the odds of the trade working out in your favour.
You can look at the statistics that you have based on your trade journaling, or you can look at the market structure to see how many obstacles there are in your way before the price can reach your target.
Let’s do a quick recap…
- Risk-reward ratio on its own is meaningless, you need to combine it with your winning rate
- To find out if the potential risk-reward on a trade is worth it, ask yourself how likely the price is going to move in your favour, based on your past statistics through your trading journal
- You can also look at the market structure to see if the market is likely to reach your target or not – if you’re trading against the trend with a lot of obstacles to overcome, then that trade is unlikely to hit your target
With that said, I wish you good luck and good trading. I will talk to you soon.