Is Risk:Reward the Holy Grail of Strategies?
If you give risk:reward the thought that it deserves you will soon understand just how powerful of a role it can play. You will quickly understand how, all by itself, it could make or break you as a trader. In this lesson, we will take a look at the numbers game behind risk:reward, but before we do that it is also important to quickly review the power of what you have learned so far.
If you are able to master your trading psychology and properly use the price action confluence of a solid location, chart patterns, market structure, entry trigger, and market layers, your win rate will very easily be 70% or higher. This is not something you will be able to achieve overnight and it will take time. You won’t know your win/loss ratio until you have been trading for a while but you will be able to determine it before you start trading live. Let’s take a look at how applying a risk:reward strategy to your trading plan can help you succeed no matter what your win/loss ratio is. This is a very important piece of your puzzle.
Use Simple Math to Your Advantage
Don’t worry if maths is not your strong point, there is nothing complicated about this. Let’s assume that you will always risk 2% of your account on every trade that you take. As outlined in the stop loss lesson; you can avoid the need to worry about different size stop loss’s on each trade by using a percentage risk. Not every trade is going to have the same size stop loss so this is a great approach if you want to eliminate the need to think about it. Membership here at WaveFX Trading will give you access to Expert Advisors that will take care of that for you.
In this following table, we will base everything upon having taken 10 trades using different risk:reward ratio’s each time. Each example results in the same 4% profit for your trading account, yet each example has a different amount of trades won vs lost. 1:1 should always be considered as your minimum risk:reward requirement for any single trade. A 1:5 risk:reward trade is not something you will find very often but it does serve its purpose here as an example.
| Risk:Reward = 1:1 | Risk:Reward = 1:2 | Risk:Reward = 1:3 | Risk:Reward = 1:5 |
|---|---|---|---|
| Risk = 2% | Risk = 2% | Risk = 2% | Risk = 2% |
| Reward = 2% | Reward = 4% | Reward = 6% | Reward = 10% |
| Trades Won = 6 | Trades Won = 4 | Trades Won = 3 | Trades Won = 2 |
| Trades Lost = 4 | Trades Lost = 6 | Trades Lost = 7 | Trades Lost = 8 |
| TotalProfit = 4% | Total Profit = 4% | TotalProfit = 4% | Total Profit = 4% |
For those of you who prefer to view everything in pips instead of percentages here is another table with the exact same information. If you had a plan that allowed you to always limit your stop loss to the exact same amount of pips every time, then you could look at it this way. Based on taking 10 trades this is how it would all play out for the same total profit.
| Risk:Reward = 1:1 | Risk:Reward = 1:2 | Risk:Reward = 1:3 | Risk:Reward = 1:5 |
|---|---|---|---|
| Risk = 50pips | Risk = 50pips | Risk = 50pips | Risk = 50pips |
| Reward = 50pips | Reward = 100pips | Reward = 150pips | Reward = 250pips |
| Trades Won = 6 | Trades Won = 4 | Trades Won = 3 | Trades Won = 2 |
| Trades Lost = 4 | Trades Lost = 6 | Trades Lost = 7 | Trades Lost = 8 |
| Total Profit = 100pips | Total Profit = 100pips | Total Profit = 100pips | Total Profit = 100pips |
The fact is that if you trade using the evidence based approach outlined here, then you do not get to decide what the risk:reward ratio on a trade will be. The strategy outlined will however allow you to know what the risk:reward ratio on any given trade is, before you enter! In turn this means that you can decide what the minimum risk:reward ratio you will accept is going to be. If the trade setup that you are seeing does not meet that minimum then you just need to sit out and wait for the next one.
A Very Conservative Calculation
Earlier on in this lesson, you were told that a 70% win rate is very possible with the approach that has been outlined in these lessons. A higher win rate than that is also possible so let’s assume a lower win rate to be conservative. Based on only ever winning 60% of your trades here is another look at those same risk:reward ratios to compare the outcomes.
| Risk:Reward = 1:1 | Risk:Reward = 1:2 | Risk:Reward = 1:3 | Risk:Reward = 1:5 |
|---|---|---|---|
| Risk = 2% | Risk = 2% | Risk = 2% | Risk = 2% |
| Reward = 2% | Reward = 4% | Reward = 6% | Reward = 10% |
| Trades Won = 6 | Trades Won = 6 | Trades Won = 6 | Trades Won = 6 |
| Trades Lost = 4 | Trades Lost = 4 | Trades Lost = 4 | Trades Lost = 4 |
| Total Profit = 4% | Total Profit = 12% | Total Profit = 28% | Total Profit = 52% |
By always winning 60% of the trades that you attempt you can see the mathematical advantaged that a risk:reward strategy can provide. It’s not complicated, but it is powerful, and it should play a part in your complete trading plan.
Finding Your Risk:Reward Balance
Flipping a coin would give you a 50% chance of getting a trade correct. The whole purpose of you studying right now is to tip the scales further in your favor than that. Knowing that it is possible to achieve a 70% win rate and that flipping a coin gives you a 50% chance, why not assume that with the correct knowledge you can achieve a 60% win rate. Based on that 60% win rate; if you have a minimum 1:1 risk:reward ratio as a rule then you are keeping that small advantage knowledge has given you. That 1:1 is just a minimum though and you will also get plenty of 1:2 and even 1:3 risk:reward trades. That only pushes things even further in your favor.
If you progress along with your trading and notice that you are only winning 50% of your trades, make a small adjustment. Your minimum risk:reward rule on any one trade could be changed to 1:1½ or 1:2. That would make winning 50% of your trades profitable and you could always adjust it again later on once your win/loss rate improves.