Don’t be fooled by the risk reward ratio — it’s not what you think. You can look for trades with a risk reward ratio of 1:2 and remain a consistent loser (and I’ll prove it to you later).
This post was originally posted here. The writer, Rayner Teo is a veteran community member and blogger on InvestingNote, with username known as Rayner and has 457 followers.
You can look for trades with a risk-reward ratio of less than 1 and remain consistently profitable.
Because the risk-reward ratio is only part of the equation.
But don’t worry.
In this post, I’ll give you the complete picture so you’ll understand how to use the risk-reward ratio the correct way.
And after reading this guide, you’ll never see the risk-reward ratio the same way again.
Then let’s begin…
What is risk-reward ratio — and the biggest lie you’ve been told
The risk-reward ratio measures how much your potential reward is, for every dollar you risk.
You get my point.
Now, here’s the biggest lie you’ve been told about the risk reward ratio
“You need a minimum of 1:2 risk reward ratio.”
Because the risk-reward ratio is meaningless on its own.
Don’t believe me?
Here’s an example:
Let’s say you have a risk reward ratio of 1:2 (for every trade you win, you make $2).
But, your winning rate is 20%.
So out of 10 trades, you have 8 losing trades and 2 winners.
Let’s do the math…
Net loss = –$4
By now I hope you understand the risk reward ratio by itself is a meaningless metric.
Instead, you must combine your risk-reward ratio with your winning rate to know whether you’ll make money in the long run (otherwise known as your expectancy).
The secret to finding your edge (hint: the risk-reward ratio isn’t enough)
Do you want to know the secret?
Here it is…
E= [1+ (W/L)] x P – 1
W means the size of your average win
L means the size of your average loss
P means winning rate
Here’s an example:
You made 10 trades. 6 were winning trades and 4 were losing trades.
This means your percentage win ratio is 6/10 or 60%.
Next, apply these figures to the expectancy formula:
E= [1+ (500/400)] x 0.6 – 1 = 0.35 or 35%.
In this example, the expectancy of your trading strategy is 35% (a positive expectancy).
This means your trading strategy will return 35 cents for every dollar traded over the long term.
So here’s the truth:
There’s no such thing as… “a minimum of 1 to 2 risk reward ratio”.
Because you can have a 1 to 0.5 risk reward ratio, but if your win rate is high enough… you’ll still be profitable in the long run.
The most important metric in your trading is not your risk reward ratio or winning rate.
It’s your expectancy.
How to set a proper stop loss and define your risk
Now, you don’t want to place a stop loss at an arbitrary level (like 100, 200, or 300 pips).
It doesn’t make sense.
Instead, you want to lean against the structure of the markets that act as a “barrier” that prevents the price from hitting your stops.
Some of these market structures can be:
Next, you must have the correct position sizing so you don’t lose a huge chunk of capital when you get stopped out.
Here’s the formula to do it:
Position size = Amount you’re risking / (stop loss * value per pip)
Your risk is $100 per trade
Your stop loss is 200 pips
Your value per pip is $10 (this number changes according to the currency you trade)
Plug and play the numbers into the formula and you get…
100 / (200 * 10) = 0.05 lots
This means if your risk is $100 per trade and your stop loss is 200 pips, then you’ll need to trade 0.05 lots.
If you want to learn more, go read The Complete Guide to Forex Risk Management.
How to set a proper target and define your reward
This is one of the most common questions I get from traders:
“Hey Rayner, how do I set my target profit?”
Well, there are a few ways to do it…
But generally, you want to set a target at a level where there’s a good chance the market might reverse from — which means you expect opposing pressure to come in.
Here are 3 possible areas to set your target profits:
- Support and Resistance
- Fibonacci extension
- Chart pattern completion
Let me explain…
1. Support and Resistance
Here’s a quick definition of Support and Resistance…
Support – An area where potential buying pressure could come in.
Resistance – An area where potential selling pressure could come in.
If you’re in a long position, then you can consider taking profits at Resistance.
If you’re in a short position, then you can consider taking profits at Support.
This technique is useful if the market is in a range or a weak trend.
Don’t aim for the absolute highs/lows for your target because the market may not reach those levels, and then reverse.
So, be more conservative with your target profits and exit a few pips “earlier”.
2. Fibonacci extension
A Fibonacci extension lets you project the extension of the current swing (at the 127, 132, and 162 extension).
This technique is useful for a healthy or weak trend where the price tends to trade beyond the previous swing high before retracing lower (in an uptrend).
Won’t it be great if you can “predict” how high the price will go — and exit your trade before the price retraces?
That’s when Fibonacci extension comes into play.
Here’s how to use it…
- Identify a trending market
- Draw the Fibonacci extension tool from the swing high to swing lo
- Set your target profits at the 127, 138, or 162 extension (depending on how conservative or aggressive you are)
And vice versa for an uptrend.
Here’s an example:
TradingView’s Fibonacci extension tool doesn’t come with 127 and 138 levels.
So, you must tweak the settings to get those levels.
Here’s how the settings will look like:
3. Chart pattern completion
This is classical charting principles where the market tends to find exhaustion when a chart pattern completes.
You’re probably wondering:
“How do you define complete?”
Well, if the price moves an equal distance from the chart pattern, it is considered complete.
Does it make sense?
Because in the next section, you’ll learn how to analyze your risk to reward like a pro.
Let’s move on…
How to analyze your risk reward ratio like a pro
So… you’ve learned how to set a proper stop loss and target profit.
Now it’s easy to calculate your potential risk reward ratio.
Here are 3 simple steps to do it:
- Find out the distance of your stop loss
- Find out the distance of your target profit
- Distance of target profit/distance of stop loss
Let’s assume your stop loss is 100 pips and target profit is 200 pips.
Apply the formula and you get…
200/100 = 2
This means you have a potential risk reward ratio of 1:2
How to use TradingView to calculate your risk reward ratio easily
Now, if you use TradingView, then it makes it’s easy to calculate your risk to reward ratio on every trade.
Here’s what you need to do:
- Select the risk reward tool on the left toolbar
- Identify your entry, stop loss and target profit
And it’ll tell you your potential risk to reward on the trade.
The risk reward ratio tool tells you what your position size should be given the size of your account and your risk per trade. Here’s how…
Double click the risk reward ratio tool on the chart, and you can change the settings …
Cool stuff, right?
You risk reward ratio doesn’t give you an edge. Here’s what you need do…
Now, remember this one thing.
Your risk reward ratio is a meaningless metric by itself.
You must combine your risk reward ratio with your winning rate to quantify your edge.
And the way to do it is to execute your trades consistently and get a large enough sample size (of at least 100).
You might be wondering:
“But what if after 100 trades, I’m still losing money?”
Don’t be disheartened.
It’s not the end of your trading career.
In fact, you’re probably ahead of 90% of traders out there as you clearly know what’s not working.
If your trading strategy is losing you money, here are four things you can do to fix it…
- Trade with the trend
- Set a proper stop loss
- The “highway” technique
- Trade the juiciest levels
Here’s how to do it…
1. How to trade with the trend and improve your winning rate
It’s a no-brainer that trading with the trend will increase the odds of your trade working out.
So here’s a guideline for you…
If the price is above the 200-period moving average, look for long setups
If the price is below the 200-period moving average, look for short setups.
And if you’re in doubt, stay out.
2. How to set a proper stop loss so you don’t get stopped out unnecessarily
Here’s the thing:
You don’t want to be a cheapskate and set a tight stop loss… hoping you can get away with it.
It doesn’t work that way.
If your stop loss is too tight, then your trade doesn’t have enough room to breathe. And you’ll probably get stopped out from the “noise” of the market — even though your analysis is correct.
So, how should you place your stop loss?
Well, it should be at a level where it will invalidate your trading setup.
If you’re trading chart patterns, then your stop loss should be at a level where your chart pattern gets “destroyed”.
If you’re trading Support and Resistance (SR), then your stop loss should be at a level where if the price reaches it, your SR is broken.
Let’s move on…
3. The highway technique that improves your risk to reward
Here’s the deal:
When you enter a trade, you want to have little “obstacles” so the price can move smoothly from point A to point B.
But the question is:
How do you find such trading opportunities?
Let me introduce to you the highway technique because this is like driving on a highway where you have little to no traffic in your way.
Here’s how it works:
Before you enter a long trade, make sure the market has room to move at least 1:1 risk reward ratio before approaching the first swing high (and vice versa for short).
Because you have a good chance of getting a 1:1 risk reward ratio on your trade as there are no “obstacles” nearby (till the first swing high).
If you want to further improve your risk to reward, then look for trading setups with a potential 1:2 or 1:3 risk reward ratio before the first swing high.
However, this reduces your trading opportunities as you’re more selective with your trading setups. Thus, you’ll need to find a balance to it.
4. Trade the juiciest levels
You’re probably wondering:
“What do I mean by juiciest?”
Well, you want to trade Support and Resistance levels that are the most obvious to you.
Because these are levels that attract the greatest amount of order flows — which can result in favorable risk to reward ratio on your trades.
Here’s how to find the juiciest levels:
- Zoom out the chart of your trading timeframe
- Mark out the most obvious levels
- Trade those levels only
Here are a few examples:
A level is more significant if there is a strong price rejection.
This means the price spent only a short time at a level before moving away (and it looks like a spike).
So in this post, you’ve learned:
- The biggest lie you’ve been told about the risk reward ratio
- How to combine your risk reward ratio and win rate to find your edge in the markets
- How to set a proper stop loss and define your risk
- How to set a proper target and define your reward
- How to analyze your risk reward ratio like a pro
- 4 practical tips that can turn your losing strategy into a winner
Now here’s what I would like to know…
“How do you use the risk reward ratio in your trading?
Once again, this article is a guest post and was originally posted on Rayner‘s profile on InvestingNote.
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