Uncovering Common Myths
When I first started to learn about trading the markets I read loads of books. I still do, I love to learn. Something that you can’t help to come across is the old recommendation of the 2:1 or 3:1 reward to risk ratio trades. This subject came to my attention the other day when talking with a group of traders and inspired me to write this article.
When researching the subject of reward to risk whether in trading books or on websites you will be overwhelmed with quotes like this:
The golden rule of risk:reward is that from each trade your reward should be at least 3x your risk meaning the risk reward ratio should be at least 1:3.
What Is a 3:1 Reward to Risk Ratio?
Whenever you look to take a trade you need to know at least 3 things before you enter it:
- Price of entry
- Stop loss, or the price you will exit the trade if it is going against you and you’re losing money
- Your exit strategy. (For this example we will take profits at a pre-determined profit level)
Let’s say a stock is trading at 105p. And we want to enter, in this case buy in at this price.
We think that if the stock goes lower than 100p then the trade is not working out and we want to exit the trade taking a small loss to prevent any further losses. This will be our stop loss.
We have reason to believe the stock is rising well and decide to take profits if the price goes up to 120p. This is our simple exit strategy for profit taking.
This is a basic 3:1 reward to risk ratio trade. Because:
The Risk is calculated: Entry price 105 – the Stop Loss price 100 = 5p
The Reward is calculated: Profit taking exit or target price 120 – Entry price 105 = 15p
So you see that the Reward is 15 and Risk is 5 so a Reward to Risk (RR) ratio of 3:1
Don’t Be Mislead
You’ll read recommendations to only take at least 3:1 RR trades all the time. But what you won’t read about so often is another VITAL piece of information:
Win Rate
If you don’t already know, as a trader you cannot be “right” all the time. You have to take losses some of the time.
As a technical trader, before I trade any individual strategy, I like to know a few “characteristics” of the strategy. These are obtained by back testing amongst other things but aren’t 100% accurate. But I can get a good idea of how a strategy will perform in the future.
In addition to Reward to Risk ratio I want to know the average Win Rate.
So if I was to take 100 trades according to the strategy rules, on average how many would be winners and how many would be losers.
3:1 Reward to Risk Ratio but Drastically Different Results
We’ll look at 2 different strategies. We will take profits of 3 times the risk using each strategy.
However Strategy A has an average win rate of 80% and Strategy B has an average win rate of 20%
Let’s look at the results of taking 100 trades using each strategy and assume that we risk 1% of our account value on each trade.
After 100 trades these are the results: Remembering a loss is a loss of 1% and a win at 3:1 is a gain of 3% (account value)
Strategy A:
- 80 Wins so 80 x 3% = 240% gain
- 20 Losses so 20 x 1% = 20 % loss
Overall result is 240-20 = 220% Gain
Strategy B:
- 20 Wins so 20 x 3% = 60% gain
- 80 Losses so 80 x 1% = 80% loss
Overall result is 60-80 = 20% Loss
Don’t Just Take Reward to Risk Ratio Into Account
From that simple example above I hope I have been able to show you that when somebody tells you not to trade unless there is potential for that 2:1 or 3:1 reward to risk ratio, you need to know other factors like win rate too.
Out of interest, going back to the examples above, if you traded a strategy with an 80% win rate and your profit was only half the risk size so Reward to Risk ratio of 0.5:1, you could still make money!
- 80 wins so 80 x 0.5% = 40 % gain
- 20 Losses so 20 x 1% = 20 % loss
Overall result is 40-20 = 20% Gain
To Conclude
So there you have same basic building blocks required to create a profitable trading strategy.
I must stress that in addition to knowing Reward to Risk ratio and Win rate, there are other factors to take into account but that’s for a different article.
If you would like to see 6 real money making strategies which don’t necessarily have the 3:1 reward to risk ratio then take a look at my popular trading course HERE.
Since writing this article I have made an updated version including a video demonstrating a test of reward to risk ratios between 0:1 and 5:1 The results are quite eye opening! Read that new post HERE
Thanks for taking the time to read this article today and I really hope that this insight can help you along the way to becoming even more profitable. Don’t forget to leave any comments or questions below or you can email me at jarrod@thetransparenttrader.com
Jarrod