Risk and reward, how much you are willing to risk to win how much? We ask ourselves this sort of question every day in life. Often it is not something so obvious, taking the risk of crossing the road, there is a risk of getting hit and the reward is getting to the other side, the risks are actually pretty large, getting hit could be devastating, but we do things to help reduce the risks such as looking each way or only crossing at a designated crossing area. We need to make these decisions in trading too, but the outcomes are often much more complicated and so is the decision-making process that we use.
If I was to offer you a 50/50 choice, the markets go up or the markets go down, you will win $10 if correct and lose it if wrong, the markets are random at this point, would you take it? The majority of people would actually say no. So let’s change it up a bit, it was the same 50/50 decision, but this time you will win $20 or lose $10, it’s a bit better but many would still say no. So what about winning $50 or losing $10, for a 50/50 chance the possible outcome of winning an additional $50 is looking quite tempting. So when you take that chance, in reality, it is beneficial to yourself to take the bet when the outcomes are that you can lose $10 but win $10.01, as the monetary value would be in your favour, but the majority of people would not take it.
So let’s change it up a bit, let’s suggest that there are some additional probabilities, you can work them out and it is now a 75/25 percent chance that the markets will go up. At what point would you consider making the same bet, would you do it for the $10/$10 or the $20/$10? This is more in line with how the forex markets work, we are able to limit our loss with a stop loss, but the take profits are where we need to consider how we place our trades.
So let’s assume that we are making a few trades, we are planning to risk 1$ of our account on each trade, with a $1000 account that means that we will be risking $10 per trade. Would you want to risk that $10 for another $10, probably not, many traders aim for a 2:1 ratio. So for every win, they will get twice the amount back that they risked. Some traders like to increase it further, so 3:1 which means that they only need one win out of three trades to be in profit, sounds good, so let’s go higher. A 1:5 ratio means that you can be in profit if just 1 in 5 trades win, however with the reward part being so high, it means that the markets will need to move a lot, and there is a far greater chance of a reversal.
It all comes down to personal choice, if we take a look at a lot of the more popular strategies out there, are they getting a 50% win rate, a lot of them actually aren’t, many are hitting 40% or 30% which may seem quite low, however having a risk/reward ratio of 1:30 means that all of those strategies are actually in profit. Then again, there are those that go even lower, seeing people with a risk-reward ratio of 0.4:1 which means that they would require a win rate of 71%, which is pretty easy right? Not something we would recommend.
It is important to find the ratio that works for you, it will be based on a couple of things, firstly your actual strategy, different strategies will work with different a different ratio, you will also need to take your own risk profile into consideration, if you hate risk then you probably want to go a little higher, but it is entirely up to you. It may take you some time to get used to a certain ratio.
Once you do find the ratio that works for you, it is important to stick with it, do not jump around different ratios, this will only cause issues with your overall results. Keep looking and eventually, you will find the risk-reward ratio that is right for you.