For many traders, the concept of risk-to-reward ratio is vitally important in achieving success. But what exactly is this ratio and how can you use it to improve your trading? In this post, we’ll take a look at the answer to these questions and more. So strap in and get ready to learn about one of the most essential tools in a trader’s toolkit.
Reward-to-Risk Ratio Defined
The reward-to-risk ratio for traders is the amount of reward each trader can expect to gain compared to the amount of risk they are taking. It is typically used to determine whether a particular trading opportunity should be pursued or not.
Additionally, traders must assess their risk tolerance before making any decisions as any strategy with an unbalanced or unsustainable reward-to-risk ratio can become counterproductive. Understanding both the potential rewards and risks associated with trading is essential in order to make successful investments in the long run.
Calculating the Reward-to-Risk Ratio
To calculate the reward-to-risk ratio, simply divide the unit value of the possible gain by the number of units risked. For example, if a trader sees a trade opportunity with the possibility to gain 20 pips and is risking 10 pips, then their reward-to-risk ratio would be 2:1 (20/10 = 2). Understanding the reward-to-risk ratio gives traders knowledge about how much risk they can afford to take when considering different trades. It also allows them to make informed decisions and maximize returns while minimizing losses.
Good Rule of Thumb – 3:1 Reward-to-Risk Ratio
Many trading experts recommend a 3:1 reward-to-risk ratio on trade setups — but the ratio you choose is obviously up to you. With a 3:1 ratio, you stand a good chance of maintaining profitability in the long run.
Check out the following chart that illustrates how a 3:1 reward-to-risk ratio can work in your favor — even if only half of your trades are winners.
As you can see, even winning only 50% of the time, you still make a profit of $5,000. That’s because, when you trade with a positive reward-to-risk ratio, your odds of maintaining profitability are increased, even with a lower win percentage.
Reward-to-Risk Ratio in Practice
Reward-to-risk ratio can have different implications depending on the type of trader you are. For example, if you are a scalper wanting to risk only 3 pips or units, a 3:1 ratio means you are targeting a 9 unit profit. But wait… A 2-unit spread is going to eat into your profit, meaning you’ll have to gain 11 units to achieve your desired profit — which is closer to 4:1.
However, if you are a swing trader targeting a 3:1 reward-to-risk ratio and you decided to risk 50 units, with the 2-unit spread, you need 152 units of profit to achieve your 3:1 ratio — which really isn’t too far from the actual 3:1 figure of 150:50.
In practice, reward-to-risk ratios are malleable. They can be altered depending on the time frame, trading environment, and your entry/exit points. A long-term position trade could have a reward-to-risk ratio as high as 10:1. At the same time, a scalper could go for as little as 0.8:1.
When trading, it is crucial to understand the risk-to-reward ratio in order to make informed decisions. The reward-to-risk ratio is a tool that allows traders to see the potential profit versus the potential loss for a given trade. By understanding and utilizing the risk-to-reward ratio, traders can set themselves up for success by entering trades with a higher probability of making a profit.
Disclaimer: All information provided here is intended solely for study purposes related to trading financial markets and does not serve in any way as a specific investment recommendation, business recommendation, investment opportunity, analysis, or similar general recommendation regarding the trading of investment instruments. The content, in its entirety or parts, is the sole opinion of SurgeTrader and is intended for educational purposes only. The historical results and/or track record does not imply that the same progress is replicable and does not guarantee profits or future profitable trading records or any promises whatsoever. Trading in financial markets is a high-risk activity and it is advised not to risk more than one can afford to lose.