Risk to reward ratio is something I often mention on site. I believe it is a vital ‘number’ that every trader should know about the method they are trading. With a system based method it is obviously easier to calculate but this does not mean it should be ignored if you are trading via discretionary methods.
The risk to reward ratio is calculated by dividing the potential profit by the potential risk. As an example, picture a trade going long on the FTSE 100 at 6000 with a stop at 5950 and profit target of 6100. This would give a £ value ratio of £100:£50 . Which is a risk to reward ratio of 2:1.
Note that although it is called a risk to reward ratio the ‘risk is the second number. Sometimes it is easier to quote it as a reward to risk ratio to stop some getting confused but in terms of the actual ratio numbers reward is first, risk is second.
Some refuse to care about this ratio. They say it is meaningless and in some ways they are right. It is meaningless if you are just applying it to a single trade. Its a bit like a flip of a coin; we all know the statistics behind it but one would rather have a larger sample of coin tosses rather than just one.
Also these traders often don’t know their win to loss ratio. Yet another figure they ignore. You can be sure if someone has lost their trading capital and you did an audit of their trades their failure would be found in either of those figures.
The importance of risk to reward it so allow the trader to know what size in change of strike rate they can endure before their system goes from profit to loss. Without a good risk to reward ratio i.e greater than 1:1 it will not take much to turn a winning system into a losing one.
I do accept that if you are trading a non-mechanical trading system then it gets harder to accurately calculate the ratio. This is because your expectations at the start of the trade may change and you have to close out the trade manually earlier than expected and before the profit target is hit.
But in these cases it is very clear that more often than not traders close their winners before target hits but rarely close losses before their stops are hit. It is only natural as if you stop is not hit why would you close. But this effects the ratio dramatically. A system that on paper has a 2:1 ratio could suddenly become 1:2 if you close your profitable traders too soon.
But in my opinion the risk to reward ratio will still reflect the true risk of the system. You may have to take a basket of demo trades to work this out but it will still show how much you are risking in order to make a profit. If you also compare that figure to the ‘ideal’ risk to reward ratio that is based on you initial stop and target at the start of a trade you will see how much extra risk you take on by closing a trade early.
Obviously risk to reward ratios are not very important if you have a perfect system but no one does. Those that claim to have a 90% strike rate yet have a shocking 1:4 or more risk to reward ratio fail to acknowledge the fact that because of that ratio you can calculate what drop in strike rate it will take for the system to break. In fact quite often a small drop of 5% in strike rate will be enough.
You will have probably read in my other articles of when I traded using a 50% strike rate. The risk ratio was so good that winners could drop 10% and I would still breakeven on the system.
You can not underestimate this ‘risk to reward ratio’ in my opinion.