How To Use The Reward Risk Ratio

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Rolf Risk Management, Statistics, Tradeciety Academy 15 Comments 30,149 Views

Contents in this article [hide]

Myths around the reward:risk ratio

The basics reward:risk ratio 101

The dynamic reward:risk ratio advanced concepts

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

The reward-risk ratio: the ultimate risk management tool

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Extra: Professional traders about reward:risk ratio

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 couldnt 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 youll 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 dont work.

Myth 4: Dont 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, its not as easy as that.
Using a wider take profit order means that price wont 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.

Folgen

You can't justify a bad trade with a potentially large reward:risk ratio. A bad trade always
stays aTradeciety
bad trade. - Rolf @Tradeciety
23:58 - 15 Mr 2016

66 Retweets

1414 Gefllt mir-Angaben

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

Cheat Sheet for reward:risk ratio and winrate

Your historical winrate

Minimum reward:risk ratio

25%

3:1

33%

2:1

40%

1.5 : 1

50%

1:1

60%

0.7 : 1

75%

0.3 : 1

Tradecietys 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 dont 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, lets 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 dont
fiddle with your orders to manufacture a larger reward:risk ratio that doesnt
make sense.

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 its your money, you have to protect it
being a trader means managing risk and maximize the final payout.

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).

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 its 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 whats
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.

If you want to play around with different trading statistics and get a better feeling how
different trade parameters interact, check out Edgewonks 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
Its not whether youre right or wrong thats important, but how much money you make
when youre right and how much you lose when youre wrong. George Soros
Frankly, I dont 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 hes going
to be wrong [sometimes] so if he loses a dollar and has to spend another dollar,
spending two to make five, hes 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