i. Risk is what a trader stands to lose if the trade goes against them and reward is something they stand to profit if it goes in their favour.
ii. Risk is inevitable and the best and the only thing a trader can do is to manage it.
iii. Risk to reward ratio is how much a trader stands to profit for every amount is risk being taken.
iv. Risk to reward ratio should be seen along with win rate.
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 trading 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, I 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 I 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 I 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 them winning the trade, how much should they risk and how much reward can they 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 their 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 I 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.