Understanding Risk Reward Ratio as your Key to Successful Trading
There are many components which make up the DNA of a successful, profitable trader. From patience to a well executed strategy plan, if you’re going to succeed in the constantly changing, high paced market, you’ll need to put all of the elements together in order to make it.
Out of all of the pieces that it takes to make it, none are perhaps more crucial than the risk reward ratio (RRR). All traders, whether veteran or green, need to define what their optimal RRR is according to their own unique personality traits and skills. This means that RRR’s will differ from one trader to the next, however, there are a few tips and tricks to help you get started on crafting your desirable levels.
Before we jump into tips and tricks for conjuring the ideal RRR, let’s start off with two examples of potential RRRs in action:
Imagine you’re going to risk 15 pips and we expect to win 30 pips. In order to break with 1:2 in this scenario, you will actually need to win 1 trade out of every 3 we take. This means that you’ll win 1 trade which brings back 30 pips and you may lose 2 others at 15 each, which keeps you at an even break in our portfolio. For this to be successful, you must have at least a 33% accuracy rate to maintain this break even, safe portfolio.
Now, let’s tweak these numbers. Say you can be consistent at 1:3, that will require a 25% accuracy performance. You’ll have one winner for every 3 trades you lose. For example, if you risk 10 pips and your goal is to win 30, you’ll win 1 trade which is 30 but will lose 3 more at 10 each. This keeps you at breaking even and holds your accuracy at 25%
The Risk Reward Ratio Basics
When first learning trading, the conventional wisdom regarding RRR is to try to do work at a higher than 1:2 RRR. Of course, if you’re going to be a successful trader, you should do much better than retaining an even break. This article is here to help you achieve this by showing you how to measure stats and optimize your trading based on the accuracy of the entry/exit and also help you tweak the RRR to get you over the break even, in to the profit zone.
As much as we extend targets according to risk, it means that we’re more likely to hit a stop or a losing side rather than hit our winning side. This is because the market is always fluctuating, moving up and down, and potentially impacted by major, unforeseen events. Statistically, it’s harder to reach targets according to proportion to the losing side. This means that as much as you will extend the rrr requirement for yourself, it will be harder to achieve your goals and you ultimately be less accurate with your trades.
When we use the term accuracy here, it doesn’t just mean entering the market but is applicable to the exit as well. It’s very important to measure entry to exit accuracy in order to learn your trading strategy and how it works for you. It is key to understand the accuracy of entry to your profit expectancy.
The Negative Risk Reward Ratio
Because extending your goal also reduces the accuracy of entry to exit, at some point every trader realizes that if they do simple math and use a negative risk reward ratio they can increase the entry to target accuracy. The major downside here is generally a very bad payoff.
Many traders at one point in their learning curve will realize that if they use higher risk than reward they will achieve higher accuracy. This is called a negative rrr and is a very risky game to play. However, many traders like this model because it gives them more events of success. But with these successes, come mighty failures. To put that in numbers, this means if you risk 100 pips when you want to profit 10, you’re working on a negative RRR of 10:1. You want to win 1 pip for every 10 you’re willing to risk.
In terms of accuracy to break even, you will be winning 90% of the time and only losing 10% of the time. But on the flipside, when you’re winning 90% of the time you’re only making 10 pips. When it comes to losing you’re going to be looking at giving up 9 trades worth of effort. This isn’t efficient and can cause incredible levels of frustration. This method can also give a lot of false feelings of success.
What type of RRR is Right for You?
In order to determine the answer to this question, we need to measure our trading characteristics free from RRR. For example, how many trades do we risk, how many trades do we take, etc. leaving out the variable of RRR. Think about this exercise purely with entry and exit signals that your trading strategy lays out. Take a period of demo trading or other simulation and run a diary of each and every trade. Trade only by the rules of your strategy and don’t think about RRR. What is the nature of the RR that your strategy will be comfortable with. Take at least 100-200 trades and document them all well.
For every trade you take, write the trade entry and exit. Also note how much you risk was in your stop loss and how much profit you were hoping to take. Once the trade ends, write down the highest potential of pips that you could have taken but didn’t. It doesn’t matter if the trade is a winner or a loser, you should still measure the highest potential count in the trade. Do the same for the drawdown. Mark down the lowest pip count that was on your losing side. If you don’t suffer a loss, just put down a zero.
When you reach a sufficient amount of trades, you should do an averaging summarization. First, determine if your portfolio was an overall winner. If so, move on to defining the RRR that is best for you. If you were on the losing end or if you were winning but want to continue to optimize the process for your yourself, follow these steps:
Do the average risk drawdown that all of your trades were in. Also do the average potential that your trades were making. Let’s say you had an average of 25 pips drawdown on your trades and had 100 pips potential high for all of your trades. This doesn’t mean you should be doing 4:1 RRR. It only means if you were risking 25 and you wanted to win 100, you would probably be better off with 4:1 RRR. But instead of writing it down as gospel in your trading plan, now you should do some more testing on a 4:1 RRR. See if you can achieve a preferred accuracy rate and make it work.
If you look at the table, you’ll see that the 4:1 should be around a 20% winning rate. Next, go back to your trades and place them on a chart. See if on a 20% success rate you could achieve a 4:1. If the answer is yes, remember the goal in trading is to make a profit. Being on a break even isn’t going to be good enough for the long run. But now you know your break even point so you should work to refine one of the edges of your trading strategy. This means either having more accuracy on the entry to exit or tweaking the RRR you’re taking. If you need 4:1, maybe you can try to do 1 risk unit per 3.5 trades instead. A ratio like this will likely increase your accuracy rate and give you the odds to go over your break even point into profitable territory.
Trading with your Custom RRR
Now that you know how to set your custom RRR, you need to stick to it and keep learning. It’s important to keep the trading diary and keep updating your real time strategy. Always make tweaks that lead to a more perfect system. What you’re doing is learning your own trading behavior according to stats. However, there are always deviations in statistics, so this alone will not keep you safe from market turmoil and outlying instabilities. Be aware that things will change and your strategy will need to make adjustments accordingly. These numbers only give you a benchmark and an anchor to see how you’ve been performing. These numbers won’t save you but they’ll give you a great insight into how you’re performing and what you need to do to improve yourself.