A newer trader is likely to overlook or disregard many discussions on risk/reward because they are either busy fantasizing about millions in profits or too inexperienced to understand the importance of maintaining a proper risk/reward ratio. It is completely possible to have a system that wins 99% of the time, with the other 1% wiping out an entire account if not properly managed. It is also possible to have a system that loses 99% of the time, with the other 1% maintaining a net profit.
For myself, everything begins with risk/reward. One of the first questions I ask before considering any trade is “Is the trade in the boundaries of my risk/reward ratio?” If it’s not, I immediately pass and stop wasting any more of my time. If it doesn’t fit my risk/reward criteria, I’m not interested.
Risk/reward ratio refers to the amount a trader is willing to risk versus his or her expected reward.
If your risk/reward is 1:3, you only need to win 3 out of 10 trades to turn a profit (eg risk losing 50 pips to gain 150 per trade).
For example, lets assume 10 trades with a 60 pip take profit, with a -20 pip stop loss and trading 5 contracts where 7 were losers and 3 were winners (risk/reward 1:3)
60 * 3 = 180 pips * 5 contracts = $9,000
-20 * 7 = -140 pips * 5 contracts = $-7,000
Net them out and you have a profit of $2,000
This higher your risk/reward ratio, the better. Without proper usage of risk/reward, consistency over time is extremely difficult if not downright impossible. If the math doesn’t work out, the profits simply won’t be there.
So what’s a good risk/reward ratio to use? It depends on your system and historic performance. If your win rate is better than 50% at a static risk/reward ratio, then slightly better than 1:1 is all you need to turn a profit. If your win rate is only slightly better than 30% at a static risk/reward ratio, then 1:3 is required to turn a profit.
I see little point in seeking any less than 1:3 risk/reward on all of my trades, though this is not necessarily always the case. Even though my win rate is better than 50%, by maintaining a strict risk/reward profile I am able to enhance my performance, and weed out any potentially weak-performing trades. For myself, it is a matter of discipline. 1:3 is my ‘benchmark’, but there are times when its necessary to adjust this for better bottom-line performance.
Ultimately, your risk/reward ratio should never drop below a certain level based on the historical performance of your trades. When starting off and without a good history of trades by which to measure, it is a good practice to prepare for the worst and assume at least 1:3. Once you begin to build a history of trading activity you will be better able to apply a more dynamic ratio to your routine.