What is risk?
Risk is inevitable. Everything that we do will involve some kind of risk. These risks could be those that can be foreseen and also some that are not present in hindsight but there is always a possibility of it being present.
Trading too is not immune to risks. It is a serious business where traders take on a risk with the aim of getting a return.
In trading, for instance, the most obvious risk is that of the price not moving in our desired direction and we incur a loss, while there is also a risk of you losing your internet connection and not having access to the market. This is the unforeseeable risk that we discussed.
But in trading, we do not let the unforeseeable risks take up all the space in our minds. For us traders, the biggest risk is that of price moving in the opposite direction of our trade.
How to manage risk?
There are several methods to manage and limit the risks one may be exposed to in the financial markets.
The easiest method to manage risk in trading is to have a stop loss in place every time a trade is taken. A trade plan is considered to be a good one only if it has risk management in place.
Now a stop loss isn’t to be placed at any random point on the price chart but should depend on the asset being traded and the strategy being used to trade.
A trader must know what he is trading and how he is trading it, this will only make it easier for him to know where to place his stop loss.
The second step to managing risk is by determining the amount of money that can be risked in the trade i.e. if the trade is a loser then the loss shouldn’t be a big deal.
The thumb rule here is to never risk more than 1-3% of the total capital per trade. This can totally differ from trader to trader but what’s important is that it shouldn’t be too high to cause panic but not even too low, it should be just enough.
Now that the stop loss is known and the risk parameters are set, traders have to position their trade according to the risk limits. Once these steps have been taken, irrespective of the outcome of the trade, the trader will never be in a state of panic.
What is reward?
Accept it or deny it, the major reason for individuals get into trading is for the rewards. Rewards could also differ, for one it could be the freedom trading brings, and for the other, it could be the money one could earn from trading.
For the sake of this blog post, we will stick to the monetary rewards associated with trading.
Whenever a trade is taken, a risk is also taken and it would be a useless activity if there were no rewards to be won in return for the risk that is being taken.
Just like the risks, rewards too depend on the asset being traded and the strategy being used to trade. There is no blanket reward target for trades.
One thing to note when it comes to setting a reward target or as it is known as take profits in a trade, it should be realistic. It shouldn’t be decided through greed or unruly expectations.
For instance, it would be a waste to expect a 10% move from an asset that barely moves 1% at any given time. Hence, having realistic and prudent expectations is the way to go.
Risk to Reward Ratio
Now that we have discussed risks and rewards in trading, let us combine the two and understand the importance of it in trading.
There are several traders out there that ponder over the risk to reward ratios that their trade system provides and they are constantly on the lookout for new trade systems with a better risk to reward ratio. But why all this fuss?
The risk to reward ratio basically means the amount of risk being taken to earn that amount of profit. For instance, if you are risk amount A in a trade then you are earning amount B from the trade.
It is not compulsory that the risk being taken must be equal to the reward that the trader stands to earn. But it is advisable to have a risk to reward ratio or RRR that is 1:1, i.e. the risk that is taken is equal to the reward.
The truth about the RRR
Anyone that has been involved in trading has come across traders boasting about having a winning trade that allowed them to profit 100 times of the risk they took i.e. trades with a RRR of 1:100.
If you are someone that gets excited by these huge figures of asymmetric risk to reward ratio then we suggest you re-evaluate your expectations from trading.
These numbers do sound and seem exciting but the hard truth is that these are not practical. Trading is not about having a big winner once in a while but rather it is about having small winners consistently.
There may be events where you may get a trade with a high risk to reward ratio but it will not happen from time to time and it would be futile to ponder over such trades, it will only result in you losing out on the trades that have small RRR but happen often.
All this can be drawn down to one fundamental thing, having unrealistic expectations. If trading were actually a business with such lucrative and easy opportunities then wouldn’t everyone do it and succeed in it? The reality says something else altogether.
How to use RRR?
The risk to reward ratios may not be the most important thing in trading but they shouldn’t be neglected. Let’s put this into perspective, does it seem attractive to have a 10 pip profit target with a stop loss of say 20 pips, that’s a RRR of 1:0.5. No right, but if we tell you that this might not be the case entirely.
RRR shouldn’t be looked at individually. The RRR has to be paired along with the win rate.
Win rate is the number of times the trade ends up in profits in comparison with the number of times it ends up in a loss. Win rate can be calculated only if the strategy is backtested properly.
A trader that backtests the strategy on the historical data of the asset he looks to trade will know exactly the chances of him winning the trade, how much should he risk and how much reward can he expect out of the trades.
Backtesting allows the trading process to be completely analytical and have no emotions involved. The trader can be confident about his research and allow the probabilities to play out.
Coming back to RRR and win rate, let us reconsider the above-mentioned example of a trading strategy with a 1:0.5 RRR. This might not seem attractive to many traders but if we tell you that the strategy has a 75% win rate, then what would your reaction be?
Even with that low RRR, a 75% win rate will allow you to have decent profits if the probabilities play out. This is the numbers game. And this numbers game is what makes this business of trading exciting.
Let us consider one more example, a strategy with a 1:2 RRR but only a 40% win rate. Out of 100 trades over time, it will result in complete profits only 40 times and will hit the stop loss 60 times.
If a trader follows this, he will still be sitting on decent profits at the end of the 100 trades.
Summing it up
We have discussed the risks and rewards aspects of trading. Risk is inevitable and reward is the compensation for the risk being taken.
The risk to reward ratio or the RRR is the ratio that lets one know how much is profited against the amount that is risked. This is normally determined by dividing the stop loss amount and the profit expectations.
Risks can be managed in many ways and the most obvious method is to have a risk limit and proper position size.
The most essential part of the RRR is that it should be coupled along with the win rate to have complete information about the strategy. A low RRR with a high win rate is as good as a high RRR with a low win rate.
If RRR is looked upon individually it is difficult to determine if it is good or not but when the win rate is also known, everything seems even more clear.
This practice of judging strategies on the basis of their win rate and risk to reward ratio helps to keep the entire process mechanical and practical. It is an underrated method to keep emotions out of the game.
One may not always come across strategies with the perfect win rate and RRR but it shouldn’t discourage them from trying to hunt and look for good systems.
One thing to be aware of in this is that traders must not tweak the RRR or win rate of the strategy as per their wishes in order to make it seem attractive.
Like we discussed, perform backtest, crunching in the data, and then test different RRR to find the perfect balance.
The risks to reward ratios are often taken for granted and are not given the attention it deserves. We urge you to share this blog post with anyone you know that is into trading. It will surely give them a new perspective on this.
We would also urge you to sit back at your desk and apply everything we discussed in this blog post and share the results with us. We strongly believe that it will have some or the other positive results.
Go ahead and ask questions or doubts you may have, in the comments section. We will revert to it at the earliest and we look forward to interacting with you.