How to use and calculate risk/reward ratio for trading
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You may know or may have heard of traders who generate more winning trades than losing trades but still lose money. Their wins tend to be constant and frequent but a single loss takes out two or three of their winners after which they end up in a losing position for the day. This is because their risk/reward ratio is not correct.
What is risk/reward?
Risk – amount of investment you are willing to risk in a trade
Reward – potential profit you could gain if your trade reaches the set profit target
The recommended risk/reward ratio is 1:3. This means that the potential profit is three times bigger than the risk. This is a great way to trade as one win could be enough to cover three losses. From the other side; if you lose once, you still have further two attempts to make a profit.
In reality a good ratio to use is 1:2. This means that the potential profit target is twice the size of the risk. Trading in this manner could generate more opportunities but which ratio you use is completely up to you and your trading style.
Calculating the risk/reward ratio
This is a very simple calculation. We simply need to divide the reward by the risk to work out which ratio we are using in a trade. In our example below, let’s say that our potential reward is $100 and we are willing to put up $50 worth of risk to gain that profit. Our formula is:
$100/$50 = 2
The ‘2’ figure tells us how much more our reward is compared to our risk. In this example the reward is ‘two’ times the amount of our risk so the ratio we will use is 1:2. If our profit target was $150 the answer to the calculation would be 3 – meaning that our risk/reward ratio is 1:3 and so on.
In our video tutorial we run through a great example of how to calculate and manage the risk/reward ratio as part of our money management. The example is focused on a long trade so if you are shorting use the same rule but in the opposite trading environment.