How does risk/reward work?
The risk/reward ratio measures how many dollars you’ll likely get for each dollar you risk. Most analysts, traders, and investors say that a 1:3 R/R ratio is best in most cases. We disagree with that, for reasons we will explain later. For now, let’s stick to the 1:3 ratio as the most popular one.
For every dollar you risk, you have the opportunity to earn three dollars. If you have an R/R ratio less than 1.0 (a 1:3 R/R ratio is 0.33, so it’s less than 1.0), you’ll get more than a dollar for each dollar invested in the trade. To handle the risk/reward ratio better, you should use stop-losses and take-profits. This way, you’ll know for sure that you’re not risking more than you are prepared to lose.
Importance of risk/reward ratio
The risk/reward ratio is one of the most important things for you to use if you want to become a successful trader. It helps you calculate your losses and profits and gives you another reason to think twice before opening a trade.
It would be best if you didn’t rely on the universal R/R ratio in your trading decisions. For every trade, you should determine how much you can afford to lose in a particular trade and how much you can lose today before you finish your trading.
If you see a trade that’s looking sweet because of price formations, economic background, or your inner sense, you can afford to take more risks and have a risk/reward ratio of 1:2, 1:1, or even 1:0.5. It’s OK as long as you understand why you’re entering the trade, and keep tabs on your emotions. Also, the smaller your R/R ratio (1:3 is not too small, but 1:5 is a small R/R ratio), the smaller your chances of earning in the trade. That’s because market volatility can move the price on the chart to your stop-loss, only to then reverse to your targets. It would help if you found a balance between the R/R ratio and the win rate of the trade.
Every undertaking in the market that involves any return demands a certain amount of risk. Avoid emotional decisions, as they can change your preset financial goal and lure you into making inconsistent bets. It’s always necessary to have a risk/reward ratio to take calculative risk.
Calculating the risk/reward ratio
To calculate the risk/reward ratio, start by figuring out both the risk and the reward. Both of these levels are set by the trader.
Risk is the amount of money you can afford to lose in the trade. Don’t act blindly by putting the stop-loss order at a random point on the chart just to maintain the R/R ratio. Stop-loss and take-profit levels are way more critical than the risk/reward ratio as they define whether the trade has a chance to succeed or not.
The reward is the money you get when the trade reaches the take-profit level. Just like with the risk, don’t put your take-profit levels at just any point of the chart to have a preferred R/R ratio. Sometimes it’s better to have a smaller R/R ratio but a higher win rate.
There is a simple formula that you can use to calculate the risk/reward ratio.
Risk/reward ratio (R/R ratio) = (Entry point – stop-loss point) / (take-profit point – entry point)
For example, if you buy XAUUSD at the entry point of $1800 and then place a stop-loss at $1750 and a profit target at $2000, the risk/reward ratio is:
(1800 – 1750) / (2000 – 1800) = 50 / 200 = 1:4 (0.25)
You can also calculate the R/R ratio using price points. Open a chart in MetaTrader 4 or 5 and click on the mouse wheel. A crosshair will emerge, and now you can click and drag the cursor to look for profit or loss points.
Then, move the cursor down, and you will get the possible loss.
We have 5000 points of possible loss and a 20 000-point reward. Thus, the risk/reward ratio is 4000 / 20 000 = 1:4 (0.25).
A risk/reward ratio example
First, look for a trade that catches your attention. We’ll use the XAUUSD (Gold) chart.
We spot a divergence on the RSI and assume gold is going to rise. Before entering the trade, we define our stop-loss. This should usually be placed below the support line, but we’ll move it even further to be safer. A decent support line lies at the $1800 level, so our stop-loss will be at $1790.
When trading with RSI, our take-profit should be near the closest resistance line, which is $1833. We will put our take-profit a little closer just to be sure. The result is on your screens.
Then, we need to calculate the R/R ratio. In this trade, the risk/reward ratio is:
(1800 – 1790) / (1830 – 1800) = 10 / 30 = 1:3 (0.33)
This is an example of a decent and well-organized trade. Now we can open our position and wait for the target to get hit.
What is a good risk/reward ratio?
Most traders consider 1:3 the best R/R ratio for every trader. We disagree because sometimes a tiny R/R ratio means a lower win rate. If you use a 1:1 risk/reward ratio, you have a higher chance of profiting than if you use a 1:4 risk/reward ratio. This happens because of market volatility and random fluctuations that can cause the price to swing towards your stop-loss before hitting the take-profit level.
In most cases, try to maintain an R/R ratio between 1:1.5 and 1:3. This way, you get the best of both worlds: a decent ratio to help you in trading, and no inadequate risk that may cause a series of bad trades and account-blowing consequences.
Summary
The risk/reward ratio (R/R ratio) measures expected profits and losses from investments and trades. If the ratio is bigger than 1.0, the risk is greater than the trade reward. If the ratio is less than 1.0, the reward is greater than the risk. Use it cleverly, and you will enhance your trading results in no time. Happy trading with FBS!
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