Risk:Reward Ratio And Probability | XTB's Trading Academy (2024)

FAQs

What is a good risk to reward ratio for traders? ›

In many cases, market strategists find the ideal risk/reward ratio for their investments to be approximately 1:3, or three units of expected return for every one unit of additional risk. Investors can manage risk/reward more directly through the use of stop-loss orders and derivatives such as put options.

First of all, it is not advisable to trade at all with a 1:1 risk-reward ratio. Just because of simple maths, let me give you an example. If your trade success rate is 50% your profit will be zero. In fact, you might be in minus because you will pay the commissions to the trades as well from your profits.

To calculate the risk:reward ratio, you divide the amount you stand to lose if the price moves in an unexpected direction (the risk) by the amount of profit you expect to have made when you close your position (the reward.)

A good risk/reward ratio could be seen as greater than 1:3, where you would risk 1/4 of the overall potential profit. For trading to prove profitable in the long term, a trader should not typically risk their capital for a lower risk/reward ratio, as this will mean that half or more of their investment could be lost.

For any stock you plan to scalp, you must understand the price supports, resistances and the set-up. From there, you can calculate the share sizing and the probabilities versus the risk. In scalping, a 3:1 risk to reward ratio is common (although, lower risk/reward is always more favorable).

The simplest and most effective way to protect your equity through risk management is to establish strict loss parameters and abide by them. One popular method is the 2% Rule, which means you never put more than 2% of your account equity at risk (Table 1).

A relative risk of 1.8 indicates that those exposed to a certain risk factor are 1.8 times more likely to experience the outcome than those who are not exposed.

A commonly cited benchmark in trading is the 1.5 risk-reward ratio. This ratio suggests that for every unit of risk taken (usually measured as a percentage or dollar amount), an investor should aim for a potential reward that is one and a half times greater.

Your Win Rate tells you how many of your trades are profitable, however this should never be confused with success as a trader. Many traders with high win rates are not profitable. Many studies have shown that many of the worlds most successful traders have win rates of between 40% and 50%.

The risk/reward ratio is used by traders and investors to manage their capital and risk of loss. The ratio helps assess the expected return and risk of a given trade. In general, the greater the risk, the greater the expected return demanded. An appropriate risk reward ratio tends to be anything greater than 1:3.

What is a 2:1 trade? ›

For example, a win/loss ratio of 2:1 means the trader has twice as many winning trades as losing. Sounds good, but if the losing trades have dollar losses three times as large as the dollar gains of the winning trades, the trader has a losing strategy.

The 1% rule demands that traders never risk more than 1% of their total account value on a single trade. In a $10,000 account, that doesn't mean you can only invest $100. It means you shouldn't lose more than $100 on a single trade.

To increase your chances of profitability, you want to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run.

Using R to Calculate Minimum Win Rate

The reason is that we can use R to calculate the minimum win rate we need to get in order to be profitable. So let's say that your average trade has a risk of 10% and a target reward of 25%. This gives you an R of 25/10, or 2.5.

The 1.5 Risk-Reward Ratio: Balancing Risk and Reward

A commonly cited benchmark in trading is the 1.5 risk-reward ratio. This ratio suggests that for every unit of risk taken (usually measured as a percentage or dollar amount), an investor should aim for a potential reward that is one and a half times greater.

The risk/reward ratio measures the difference between the entry point to a stop-loss and a sell or take-profit point. Comparing these two provides the ratio of profit to loss, or reward to risk.

Here's another example: Let's say you buy a stock priced at $500 and have a stop loss at $480, meaning that 1R is equal to $20. Then the stock's price increases to $540 and you take profit. You have taken $40 or 2R profit.

Once the risk level is set, you then determine your reward level, which is how much profit you want to target on the trade. A common risk-reward ratio is 1:2, meaning you aim to make twice as much profit as you're risking on the trade.