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How to use the Reward Risk ratio like a professional

The reward to risk ratio (RRR, or reward:risk ratio) is a very controversially discussed trading topic and while some traders claim that the reward:risk ratio is totally useless, others believe it is the Holy Grail in trading. In the following article we explain how to use the reward risk ratio correctly, share some lesser known facts about the concepts and demystify the ideas behind the reward:risk ratio.

 

Myths around the reward:risk ratio

 

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. Although, the reward:risk ratio by itself has no value, when you use it in combination with other trading metrics, 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 randomly chosen “minimum” risk reward ratio? Even popular trading books often state that trades with a reward:risk ratio of smaller than 2:1 or 3:1 have to be avoided. This is very wrong and can even lead to a decline in trading performance.

Whenever you read something like that, leave the website immediately. As we will see shortly, the optimal reward:risk only depends on YOUR own trading strategy and YOUR performance, and on nothing else. There is nothing like good or bad reward:risk ratios.

 

Myth 3: Mental stops and not using stops is better

Once a trader is aware of how the concept of the reward:risk ratio works, he will see that trading profitably without having an exact and fixed price level for his stop is impossible. Only if you know where you will place your stop loss order before entering the trade, you are able to calculate your reward:risk ratio, the required winrate and judge whether a trade has a positive expectancy for you or not – we take you through an example below. Mental stop loss orders don’t work.

 

Myth 4: Don’t justify bad trades with large reward-risk ratios

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, increase the expectancy of 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 the amount of 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 below shows that). When you know the reward:risk ratio for your trade trade, you can easily calculate the required winrate (see formula below). You can quickly see whether the reward:risk ratio is large enough for your historical winrate or if you should skip that trade when the reward:risk ratio is too small.

General formulas 

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

or

Required Reward:Risk Ratio = (1 / Winrate) – 1

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

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

Example 2: If your system has a historical winrate of 60%, you need a reward:risk ratio of  0.6 : 1 to achieve a long-term expectancy:

(1 / 0.6) – 1 = 0.7

RRR_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.

 

 

 

 

 

 

The dynamic reward:risk ratio – advanced concepts

When you are in a trade and price starts moving in your favor, the reward:risk ratio of the trade declines since the distance from the current price to your stop increase. A declining reward:risk ratio leads to a variety of changing risk metrics that we will explore further now.

Just before price is about to hit your take profit order, the risk reward ratio is worst and making the correct trading decision can become very difficult. The question then becomes, do you take a profit early and don’t risk giving back your unrealized profits, do you still believe in your trade idea and let it run, or do you move your stop to protect your trade and wait it out?

Whereas there is no right or wrong answer to this question, it is important to be aware of the dynamics here and analyze how managing positions and profit taking influences your performance over the long term. Exiting trades correctly can make a big difference in your performance.

Below, we will now walk you through a trade example and show you how the risk parameters of a trade change when price moves.

 
 

A step by step trade example – how to use the reward risk ratio

 

1) You enter a trade

For the sake of the argument, let’s say we are entering the short trade on the break of the pinbar. At that point, the risk reward ratio is 2:1 (240/120) and our minimum required winrate is 33.3% (1/1 +2). This means that if your historical winrate is greater than 33.3% we can safely take the trade. If your winrate would be lower, however, you would have to skip the setup, even when it has all the entry criteria going for it and don’t fiddle with your orders to manufacture a larger reward:risk ratio that doesn’t make sense.

rrr_scenario1

 

2) Price moves in your favor – the reward:risk ratio declines

After price has moved in our favor, you have to reassess the situation. If you leave the stop loss order at its initial level, the new reward:risk ratio drops to 0.2 (60/270) and the required winrate is now 83% ( 1/1 + 1.2).

Traders get this wrong: You have to be aware of the fact that you are not trading with free money when your trade is in profit. Most traders believe that unless they have closed the trade, the money they see in their floating P&L is not theirs – dead wrong. Once you start treating the money in the P&L like it’s your money, you have to protect it – being a trader means managing risk – and maximize the final payout.

rrr_scenario2

 

Ask yourself the following questions when making mid-trade decisions:

  • What is the current reward:risk ratio and the required winrate?
  • Would I enter the trade with the current stop loss and take profit levels and the current risk reward ratio as it is now?
  • If not, is there a reasonable price level where I can move my stop loss order to, to increase the reward:risk ratio?
  • If not, what are the odds of price reaching your take profit? Is it still looking good or is price struggling?

 

 

3) Trailing your stop the right way

There are multiple ways to trail stops and there is no right or wrong. The most important point is that you have a systematic approach that enables you to trail your stop to reasonable levels where the chances of premature squeezes are minimized.

In our example, we have trailed the stop above the previous candle highs. Now, your new reward:risk has increased to 1:1 (60/60) and the required winrate dropped to 50% (1/1+1).

rrr_scenario3

Other ways and methods you can use to trail stops are:

  • Swing highs and lows – very popular and effective
  • High and low of the day
  • Support and resistance
  • Moving averages – especially helpful during trending market periods
  • ATR as additional information. Stop loss setting based on volatility
  • Based on natural price patterns or chart formations

 

 

4) The realized reward:risk ratio – the R-Multiple

The concept of R-Multiple (which stands for Risk-multiple) is similar to the reward:risk ratio, but it’s more of a performance metrics that looks at closed trades. The R-multiple measures your trades in terms of risk, where it defines the distance between your entry and the stop loss as 1R.

Thus, a trade you close for a loss at your initial stop loss level is a -1R loss. A winning trade that makes twice the amount of your initial risk (a 2:1 reward:risk ratio) would be a +2R trade. You get the idea…

The R-multiple concept comes in really handy when you start comparing your initial reward:risk ratio to the completed R-multiple. If you overestimate the reward potential and see a large difference between the initial reward:risk and the final R-multiple, you should take a look at the premise of your methodology. Are you overly optimistic? Do you close trades too early? What is happening exactly? Such insights are invaluable and they will make a big difference in your trading; the easiest way to find out what’s working or not is by consulting your trading journal.

 

The reward-risk ratio: the ultimate risk management tool

The concept of the reward:risk ratio is far more than just dividing your take profit distance by your stop loss distance and then shooting for a random, high number. The reward:risk ratio determines your long-term profitability and it is a dynamic concept. Professional traders (see below) view themselves as risk managers and assessing risk and managing the downside should be your top priority. We highly encourage you to start paying more attention to your planned, realized and mid-trade risk parameters and evaluate how you manage your trades.

 

rrrwinrate11

If you want to play around with different trading statistics and get a better feeling how different trade parameters interact, check out Edgewonk’s performance simulator or use our reward-risk calculator.

 

 

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 draw down 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

About Rolf

8 comments

  1. Where does the 3.4 come from ?

  2. The problem with Risk/Reward is that you can never know the Reward, only the Risk.

    Any potential Reward you perceive is a complete figment of your imagination. It is an entirely made up guess (no matter how hard you try to justify it – statistically or otherwise).

    This is an unavoidable truth since the market has random forces acting upon it at all times.

    Furthermore, Risk/Reward is also greatly affected by trader ability.

    By that I mean there are many emotional factors that will affect traders of different ability during the trade.

    For instance, if a trader perceives a 4 to 1 R/R trade, enters and early in the trade decides to exit (out of panic or discomfort) and books a small profit, the trade is no longer a 4 to 1 R/R, it closer to a 1 to 4 (if a stop was placed at a reasonable distance from the entry).

    Same goes for a trader who enters this same trade and at some point during the trade sees activity that is likely to negate the positive outcome and exits with a profit equal to the distance from entry to stop.

    In other words, a 1/1 Risk/Reward.

    Now the big question to that trader is: Since it was only a 1/1, if you would have know that, would you have still taken the trade?

    Risk/Reward can possibly help you psychologically and help you pull the trigger but any outcome you perceive before entry is completely made up.

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