Risk reward ratio

Successful traders won’t enter a position unless they know precisely where they are going to exit it, whether profitable or not.

To determine their planned closing levels, they’ll use a risk-reward ratio.

What is a risk-reward ratio?

A risk-reward ratio is an essential part of trading successfully. It determines how much you’re willing to risk losing on any trade – and how much potential profit you need to justify that risk.

In doing so, your ratio will dictate two crucial aspects of your day-to-day trading:

1. Whether to trade an opportunity or leave it be
2. Where you close to take profits or prevent losses

Choosing opportunities

When you trade using a risk-reward ratio, you should only open positions that fit your plan.

There’s no ‘golden’ ratio that will work for every trader. To choose your own, you’ll need to balance how much profit you can realistically expect from any individual trade against how often you believe you can trade successfully.

Example

If you choose a 1:1 ratio, for example, then you’d want your potential profit from a trade to be equal to how much you are risking on it. If you could lose £250, you’d target a £250 profit.

In this scenario, you’d need to be successful more than 50% of the time to make a profit. Any losing trade would cancel out a winning one, which doesn’t leave much margin for error.

With a 1:2 ratio, on the other hand, you can earn a profit even if you aren’t right 50% of the time. It would take two losing trades to cancel out each win.

Setting realistic profit targets

The higher your ratio, the more often you can afford to make the wrong call. But how much can you expect to make from each position?

Achieving a close profit target is more likely than hitting a distant one. So, a 1:3 or 1:4 ratio will generally result in substantially fewer winning trades than 1:1 or 1:2.

Much will depend on your trading style. Day traders, for example, might need a lower risk-reward ratio – achieving large profits within a single day is tricky. Using longer-term positions, meanwhile, means you can target higher rewards.

With a ratio in place, you’ll be able to make an informed decision about each potential position. Can the opportunity deliver the return outlined in your plan? If it doesn’t, then move on to the next one.

Closing positions

To control the risk on each trade, you can use stop losses.

You’ll want to place your stop loss at the point when your prediction has been proven wrong. For example, if you’re finding positions using pullbacks and breakouts, then your stop loss could be set where a fakeout would be confirmed.

Alternatively, you could place your stop just beyond a recent support (if you’re going long) or resistance (if you’re short) level. That way, if the market begins a sustained move against you, you can limit your losses.

Taking profits

With a stop in place, the level at which you take profits is determined by your risk-reward ratio.

For example, if your ratio is 1:2 and you’ve set a stop loss 20 points below your market entry, then you would look to exit at 40 points of profit.

You might want to consider adding a take-profit order to automatically close your position at your chosen level – that way, you know you can secure a return if the market hits your target.

How much can you risk?

Your risk-reward ratio will go a long way towards helping you trade successfully. But it won’t stop you from losing all your equity if you risk too much on each trade.

As we covered in the Strategies and risk course, if you allocate 10% of your balance on each position then you only need ten consecutive losses before your wiped out. Drop that down to 2%, and you have a much larger margin for error.