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Why is Risk vs Reward in Trading Important?

Understanding how much money a trade could make against how much it could lose is an easily understood measure of the success of a trade. A forex or futures trader who does not understand this measure is likely to lose a large proportion of their trading account.

A trader that can consistently win trades with a 1:2 risk vs reward ratio is unquestionably a good trader. At Funded Trading Plus we want to find and fund unquestionably good traders because they could make us and themselves a very healthy profit.

On our Talented Trader Programme, traders who want to be funded are judged by this measure only and if they win half or more of their trades then they are more than good enough for us to entrust with our money. Once they become funded we’ll allow them to trade with a risk vs reward that suits their personal trade style. Our Talented Trader Program is a test to find the best.

What is Risk vs Reward in Trading?

Risk vs Reward is one of the most important measures of the success of a trade. It is the ratio of the risk – defined as the maximum monetary loss of a trade, versus the reward – defined as the minimum monetary gain of a trade. 

Using fundamental analysis a good trader can assess a market price that may be good for a trade entry, this may be an entry for the market to move up for the trader to buy the market from or the trader may be looking to profit in a fall in the market by selling at this entry.

The risk is the difference in points or pips between the entry price and the stop loss price. Ahead of the trade, a good trader will assess the maximum price the trader is prepared to see if the market moves against them for a loss. This is the price at which the trader will close the trade at a loss, normally this would be by using a stop loss trigger. This stop-loss price is below the entry for a long buy trade and above the entry for a short sell trade. 

The reward is the difference in points or pips between the entry price and the profit target. The profit target is the trader’s projected price point that they expect the market to move to for the trader to make a good profit. At this point the trade will normally set a sell order to close a long buy trade or a buy order to close a short sell trade.

Traders use risk vs reward to work out how much money to risk on each trade. Usually the trader will use a fixed monetary percentage of their trading account to allocate to each trade. The trader divides the allocatable monetary risk by the number of points or pips of the trade risk so that they can enter the market with an appropriate trade size.

How do you calculate the Risk-Reward Ratio?

The risk size of the trade is established by the trader  – it is the number of points or pips between the entry price and the stop-loss position. The reward size of the trade is also established by the trader and is the number of points or pips between the entry and the take profit point.

Risk divided by Reward gives the ratio. If the ratio is greater than 1.0 then the potential risk is greater than the potential reward. If the ratio is less than 1.0 then the potential profit is greater than the potential loss.

Here are two example calculations:

E-Mini S&P500

Long Trade Entry at 3840.00, stop order at 3815.00 and profit limit order at 3910.00

Risk: 3840.00 – 3815.00 = 25 points

Reward: 3910.00 – 3840.00 = 50 points

Risk/Reward: 25/50 = 0.5

This trade has a reward twice the size of the risk.

EURUSD

Short Trade Entry at 1.2190, stop order at 1.2340 and profit limit order at 1.1890

Risk: 1.2340 – 1.2190 = 0.0150 or 150 pips

Reward: 1.2190 -1.1890 = 0.0300 or 300 pips

Risk/Reward: 150/300 = 0.5

This trade also has a positive risk/reward ratio of 0.5. It will make twice as much as it risks.

What is the right Risk vs Reward for trading?

A Risk vs Reward ratio goes hand in hand with a Win-Loss ratio or percentage. The right Risk vs Reward ratio of a trade can only be decided if the trader has a reasonable expectation that a trade will win a certain percentage of the time taken in a series of similar trades. The Win-Loss ratio combined with the risk-reward ratio is also known as the expectancy. The expectancy is a forward projection of a historical figure based on previous trades or on backtesting.  This article on the Trade Room Plus website gives a great overview on this subject: Which Trading Strategies make the most Profits? 

If you are trading with a 1:2 Risk vs Reward you need to use a strategy with a win-loss of just 33% to make breakeven. If you take 100 trades and win just 33 you will breakeven. The goal is therefore to win more than 33% of your trades. Balancing your win-loss ratio with the right Risk vs Reward makes or breaks your trading career.

It is possible to make money trading with a negative Risk vs Reward ratio, but to do so requires a very high expectancy. As a rule, it’s generally better for traders to trade with a positive Risk vs Reward ratio.

How to effectively use a Risk vs Reward Ratio

To use a Risk vs Reward ratio effectively you need to establish a trade plan that takes into account:

  • Market Conditions
  • When and where to enter a trade
  • Where to place your profit targets and your stop loss

See this article: How to Make an E-mini or Forex Trade Plan

Should I trade with a high Risk vs Reward ratio?

Trading with a high risk vs reward ratio can look good in theory, “I’ll risk little to make a lot,” certainly sounds good but in practice it is very difficult to sustain. Markets move in waves rather than straight lines, predicting significantly large moves is extremely difficult and very few professional traders trade in this way. The general rule is that the higher the risk reward the lower the probability that the trade will win.

Risk vs Reward Ratio is Strategy Dependent

Every successful trader will have a favorite trading strategy and they will know what their expectancy is for the next trade that they plan to take. Continuous analysis of their past results using this strategy and the back testing they do will inform their risk vs reward decision when they place their trade. A detailed trade log helps the trader make this informed decision and it’s important that the trader makes the effort to keep their trade log up to date. A decent trade log will tell you when to change your strategy risk reward if the strategy is not performing to expectation. You can use an excel or google spreadsheet to keep a log, but we recommend that all traders use this excellent  trade log that is available from Edgewonk.Click here to open Edgewonk. Their free online trade log plan will get you started.

I have a trade strategy that works with a lower Risk vs Reward ratio

If you have a trade strategy that works well with a lower risk vs reward and you are confident you can generate great returns from this then when you are funded by our program you will be able to trade in this way.

If you are looking to pass the Talented Trader Program and get funding you’ll need to adapt your strategies for a 1:2 risk reward. If you do so and pass through the program with a 50% or greater win rate you are unquestionably a good trader and will be offered significant funding.

Conclusion

It’s vitally important for a trader to know and understand the risk vs reward of every trade they take. Without this understanding, it’s impossible to apply sound trading money management to their trading. This lack of money management is the main cause of retail trader failure and often leads to large losses. Identifying and calculating the risk vs reward is always the first step towards executing a successful trade.

Your Turn

Please comment on this post, note anything you think this post is missing and we’ll update it. Here are some questions to help you:

What risk reward do you trade with and why?

What’s the best r:r trade you’ve ever taken?

Do you cut your winners to early reducing your r:r?

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