How To Use The Reward Risk Ratio Like A Professional

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How To Use The Reward Risk Ratio Like A Professional

Let me get it out of the way: the winrate in trading it completely irrelevant on its own. Many traders put way too much emphasis on the winrate and do not understand that a winrate does not tell you anything about the quality of a system or a trader.

You can lose money with a 80% or even with a 90% winrate if your few losers are so big that they wipe out your winners. On the other hand, you can have a profitable system even with a winrate of 50%, 40% or onl 30% if you are good at letting winners run and cutting losses short.

It all comes down to your reward risk ratio.

The reward to risk ratio (RRR, or reward risk ratio) is maybe the most important metric in trading and a trader who understands the RRR can improve his chances of becoming profitable.

 

 

Reward Risk Ratio Myths

Let’s first tackle some of the common misconceptions about the RRR to help you understand what most people get wrong before we then dive into the specifics of the RRR and how to use it.

 

Myth 1: The reward risk ratio is useless

You often read that traders say the reward-risk ratio is useless which couldn’t be further from the truth. When you use the RRR in combination with other trading metrics (such as winrate), it quickly becomes one of the most powerful trading tools.

Without knowing the reward risk ratio of a single trade, it is literally impossible to trade profitably and you’ll soon learn why.

 

Myth 2: “Good” vs. “bad” reward risk ratio

How often have you heard someone talk about a generic and arbitrarily chosen “minimum” reward risk ratio?

Even popular trading books often state that you need at least a RRR of 2:1 or higher – mostly without even knowing any other trading parameters.

There is nothing like good or bad reward risk ratios. It just comes down to how you use it. You can even trade profitably with a reward risk ratio of 1:1 or less as we will see later.

Further reading: Why I prefer a low winrate trading system

 

Myth 3: A bad trade doesn’t become better with a high reward risk ratio

Often, traders think that by using a wider take profit or a closer stop loss they can easily increase their reward risk ratio and, therefore, improve their trading performance. Unfortunately, it’s not as easy as that.

Using a wider take profit order means that price won’t be able to reach the take profit order as easily and you will most likely see a decline in your winrate. On the other hand, setting your stop closer will increase premature stop runs and you will be kicked out of your trades too early.

Amateur traders often justify “bad” trades where they are not trading within their system with a larger reward:risk ratio. Your trading rules are there for a reason and a bad trade does not suddenly become acceptable by randomly hoping to achieve a larger reward:risk ratio.

 

 

The Basics – Reward Risk Ratio 101

Basically, the reward risk ratio measures the distance from your entry to your stop loss and your take profit order and then compares the two distances (the video at the end shows that).

 

Step 1: calculating the RRR

Let’s say the distance between your entry and stop loss is 50 points and the distance between the entry and your take profit is 100 points .

Then the reward risk ratio is 2:1 because 100/2 = 2.

 

Reward Risk Ratio Formula 

RRR = (Take Profit – Entry ) / (Entry – Stop loss)

and vice versa for a sell trade

reward risk ratio calculation

 

Step 2: Minimum Winrate

When you know the reward:risk ratio for your trade, you can easily calculate the minimum required winrate (see formula below).

Why is this important? Because if you take trades that have a small RRR you will lose money over the long term, even if you think you find good trades.

 

Minimum Winrate Formula 

Minimum Winrate = 1 / (1 + Reward:Risk)

 

Example 1: If you enter a trade with a 1:1 reward:risk ratio, your overall winrate has to be greater than 50% to be a profitable trader:

1 / (1+1) = 0.5 = 50%

 

 

reward risk ratio winrate

 

Cheat Sheet for reward:risk ratio and winrate

Your historical winrateMinimum reward:risk ratio
25%3 : 1
33%2 : 1
40%1.5 : 1
50%1 : 1
60%0.7 : 1
75%0.3 : 1

Tradeciety’s reward:risk calculator – Our math guide

Traders who understand this connection can quickly see that you neither need an extremely high winrate nor a large reward:risk ratio to make money as a trader. As long as your reward:risk ratio and your historical winrate match, your trading will provide a positive expectancy.

 

 

 

 

 

 

 

Finding a profitable trading strategy

Now let’s put this all together and let’s take a look at some performance statistics and how the RRR fits in.

Below, we see a performance simulation in our edgewonk trading journal based off a strategy with a winrate of 50% and a risk of 2.5% per trade. The RRR was first set to 2:1 on average per trade.

You can see that out of those 20 simulated outcomes (the different graphs), all of them were positive after 500 trades. Remember, with a winrate of 50%, you just need a RRR greater than 1:1 to trade profitably. With a 2:1 RRR you can potentially trader very profitable with a winrate of 50%.

Tip: If you know that you have a winrate of around 50%, only look for trades that offer at least 1.5:1 or 2:1 or even higher to create a buffer and accelerate your account growth.

 

Now let’s take a look at the same strategy with the same risk per trade and the same winrate. The only thing I changed was the RRR.

Now each trade has a RRR of 1:1.

You can see that out of the 20 simulated outcomes, only a few generated a positive outcome and many showed a negative outcome.

With a winrate of 50%, trading a RRR of 1:1 is very volatile and variance will be huge. Remember, with a winrate of 50%, you need a RRR greater than 1:1.

Remember: With a 50% winrate, the 1:1 RR is just the threshold which is why we recommend adding a buffer to the RRR once you know your winrate.


Here is another video I recently made where I show the connection between the RRR and winrate again.

 

 

Extra: Professional traders about reward:risk ratio

“You should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum drawdown pain and maximum upside opportunities.” – Paul Tudor Jones

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”  – George Soros

“Frankly, I don’t see markets; I see risks, rewards, and money.” – Larry Hite

“It is essential to wait for trades with a good risk/reward ratio. Patience is a virtue for a trader.” – Alexander Elder

“Paul Tudor Jones [had a principle he used to use] called 5:1. […] he knows he’s going to be wrong [sometimes] so if he loses a dollar and has to spend another dollar, spending two to make five, he’s still up $3. He can be wrong four out of five times and still be in great shape.” – Anthony Robbins on Paul Tudor Jones

“The most important thing is money management, money management, money management. Anybody who is successful will tell you the same thing.” – Marty Schwartz

Comments ( 6 )

  • Gianluca

    I have reached the same conclusions. Totally agree with the article.

  • Witbooi

    ” … only look for trades that offer at least 1.5:1 or 2:1 or even higher …” How does one spot these trades? Is it not a case of wishful thinking? After all, anything can happen after one has entered a trade. Nowadays I trade two contracts. The first is 1:1 and should the second reach 2:1 I move stop to entry and then my target becomes 3:1.

    My favorite trading quip: “Nobody knows nuttin’.”

    Thanks for posting. Your articles are of great value.

  • Roy Peters

    Excellent article.
    I keep my risk small so I can stay in the game and try not to cut winners short. It’s not easy but no one said trading is easy.

  • Anil

    hi how would this be applied when trading options short term ? swing or day trading , options being

    so volatile ?

    thanks

  • ArJuN

    Thanks for those Inspirational Quotes at the End.

  • Pankaj Bhowmick

    Sir,

    I am using Option strategy like strangle , Bull call spread etc based on my market outlook . i know my maximum loss and profit theoretically but my loss per trade is 2000 ( total capital 100000) . there is no automated way to put stop loss so i use manual stop loss . i assume my winrate is 50% and risk reward is more than 1:1.5 . but the problem with few stocks which has high lot size and more volatile so i had to put tight stoploss to be within my loss per trade 2000 . so sometime i kick out of trade early . one more question if stock does not move it becomes very tough to maintain 1:1.5 risk reward ratio. in that case should i book profit early or book loss later in case stock does not move in my direction

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