..and I’m going to prove it
In this article you are going to discover why using 2:1 or 3:1 reward to risk ratio for your trades isn’t a very good idea. In fact, I am going to show you a real study in detail demonstrating what happens when you take trades with a reward to risk ratio between 0.5:1 and 5:1
What is Reward to Risk ratio?
When looking at a potential trade to make it is quite common to look at the potential profit available which we call reward. Clearly there is risk involved in every trade too. One common way to measure risk is by placing a stop loss.
For example a stop loss of 100 pips or points is our risk. We can also set a limit order to take profit at a predefined amount of pips or points too. In this case we will use a target or reward of 200 pips giving us a reward of twice our initial risk. Expressed as a 2:1 reward to risk ratio trade.
But how do we know that 2:1 is the best reward for any given trade?
A few years ago I wrote an article which proved popular about 3:1 reward to risk ratio which you can read HERE
However in this similar article I am going to back it up with real trading results.
If you didn’t already know, I am a mechanical or rule based trader. Which means I look for certain conditions to give me entry and exit signals for each trade.
The strategy I am running the test on is quite a simple but effective one which uses an inside daily bar as a setup and then a break of the high or low to buy or sellshort. I have ran the test on AUD/USD Forex pair over 10 years ranging from 1/1/2010 until 1/1/2020.
The risk is calculated by the range of the inside daily bar, or by subtracting the low from the high. For example 120 pips. So the stop loss is 120 pips away from our entry price. So a profit target of 240 pips would give us a Reward to Risk ration of 2:1
The normal exit I use for this strategy is a timed based exit at the end of the trading session. So regardless of whether the trade is in profit or a loss, I will close the position at the end of the session.
The actual strategy isn’t the focus of this post though. The focus is to test various reward to risk ratios (profit targets) to see how the performance changes.
I have programmed the strategy and included an additional profit target using Multicharts platform which I use to test and trade strategies.
As displayed on the above optimisation report you can see the far right hand column is the reward in relation to the risk. The risk stays constant throughout the test but I have tested various multiples of reward from 0 – 5 in steps of 0.5.
Looking at the far left hand column you can see the net profit produced by the according reward ratio.
The first result or 0 reward shows the best and only positive results in this test. This is the original strategy using no profit target or reward ratio, just the timed end of session exit.
The best result using a fixed reward to risk ratio as an exit strategy was 1:1 giving a net loss of -$1,506
Definitely something you would not want to trade!
Using a reward to risk ratio of 2:1 which is the focus of this article also gives terrible results netting a loss of -$10,611
Below shows the equity curve of the same 2:1 reward to risk ratio and also the much nicer curve of the strategy using no fixed reward, just the original time based exit.
A few important points to note about choosing Reward to Risk ratios:
- Every strategy and market has a different optimal Reward to Risk ratio – what works for one, won’t always work for another.
- Sometimes using a fixed Reward multiple as an exit will lose money as you can see in this article.
- When using a fixed Reward multiple you are forcing your requirements onto the market. Sometimes the market will only offer what it has to offer.
- Often time based or signal based exits are far more profitable than using a fixed Reward multiple as a profit target.
- There are other factors such as winning percentage which determine the profitability of a trading strategy.
In addition don’t believe everything you read! You will often read about only taking 3:1 or 2:1 Reward to Risk ratio trades. But quite often these statements are either very old and/or not backed up by proof.
I recommend you test everything before trading live with real money. You can run back tests like the one I have displayed in this article. But back tests aren’t fail proof as they only show you what has worked in the past. But wouldn’t you rather trade something that has proven to work well in the past than something that has continuously lost money in the past? I know I would!
Thanks for reading,
and if you would like to see more watch the video below.
If you would like to see the exact rules for the original strategy I used in this test then click the big blue download button below the video.