For a trader, success depends on minimizing the losses and maximizing the profits. But most of the time things happens in reverse we book profits early and carry the losing positions, which minimizes the profits and maximizes the loss. To minimize the losses stop loss is very important. Stop loss should not be placed at any random level but to the trend changing level.
Before you enter into the trade you must have a proper entry and exit trading strategy. You should know when to enter and when to exit. Selection of right risk reward trade plays a very important role in the trading success. Lets check out how risk reward ratio of trade impacts the profitability.
Risk Reward 1:1
In this kind of trade your risk and reward is same. The profit and loss is 50 50 in each trade. If you are doing 3 trades a week or 12 trades in a month, your 7 trades should achieve the targets to give you ultimate profit. This means you accuracy should be above 57%
Risk Reward 1:1.5
In this kind of trade selection, your reward is 50% more than risk. For example, you get into the trade risking 1000 Rs in the expectation of getting 1500 Rs. Assuming 3 trades a week or 12 trades a month. You will be losing 3000 in the worst week and gaining 4500 in the best week. In this case, your 5 out of 12 trades should achieve the targets for a profitable month. So you need accuracy of 45%
|Risk Reward 1:1||Week 1||Week 2||Week 3||Week 4|
|SL or Target||SL Hit -1000||SL Hit -1000||SL Hit -1000||Target 1500|
|SL or Target||SL Hit -1000||SL Hit -1000||Target 1500||Target 1500|
|SL or Target||SL Hit -1000||Target 1500||Target 1500||Target 1500|
Risk Reward 1:2
With the risk reward of 1:2 you will lose 3000 in the worst week and gain 6000 in the best week. You have to get 5 out of 12 trades right but your profit will be more from the 1:1.5 risk reward case. Accuracy required in this case is 42%
|Risk Reward 1:2||Week 1||Week 2||Week 3||Week 4|
|SL or Target||SL Hit -1000||SL Hit -1000||SL Hit -1000||Target 2000|
|SL or Target||SL Hit -1000||SL Hit -1000||Target 2000||Target 2000|
|SL or Target||SL Hit -1000||Target 2000||Target 2000||Target 2000|
Risk Reward 1:2.5
With this risk-reward ratio wrong trade will result in loss of 1000 Rs and each right trade will give profit of 2500. The worst week will result in loss of 3000 and best week will give 7500 Rs . You have to get 4 out of 12 trades right for a profitable month, that means accuracy of around 35%
|Risk Reward 1:2.5||Week 1||Week 2||Week 3||Week 4|
|SL or Target||SL Hit -1000||SL Hit -1000||SL Hit -1000||Target 2500|
|SL or Target||SL Hit -1000||SL Hit -1000||Target 2500||Target 2500|
|SL or Target||SL Hit -1000||Target 2500||Target 2500||Target 2500|
To summarize the average accuracy required for different risk reward trade is
|Risk Reward Ratio||Required Strike Rate|
So you can see that better the risk reward lesser the accuracy required to make profits
Minimum Winrate = 1 / (1 + Reward:Risk)
Required Reward:Risk Ratio = (1 / Winrate) – 1
Is it so easy to make profit?
Now a question might be striking your mind if this is so easy why many traders loses money. It is not so easy to trade consistently with good risk reward ratio because not every trader can control his fear, greed and emotions. Many traders are compulsive traders they can’t wait for right opportunity and get into trade even when the risk reward is not good.
You have to be disciplined. If initial trades goes wrong consistently, traders gets emotionally disappointed and don’t take position in the next trades or take with less amount fearing the further loss. In the same way when initial trades goes right they get greedy and increases the trading amount. Which results in more loss when stop loss hits.
Traders don’t follow the strategy with discipline. They don’t book profit and loss at right levels. They exit early in small profit and carry the losing position.
What you need for trading success?
- Get in the good risk-reward trades only. Don’t be compulsive trader wait for right opportunity.
- Trade with same amount in each trade. Don’t increase or decrease the amount because of profit or loss.
- Book profit and loss at right levels only.
- Don’t stop trading if initial trades goes continuously wrong. You have to take minimum trades at least.
What famous traders says on risk-reward selection
“You should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward risk opportunities that should give you minimum draw down pain and maximum upside opportunities.” – Paul Tudor Jones
“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.” – George Soros
“Frankly, I don’t see markets; I see risks, rewards, and money.” – Larry Hite
“It is essential to wait for trades with a good risk / reward ratio. Patience is a virtue for a trader.” – Alexander Elder
“Paul Tudor Jones called 5:1 he knows he’s going to be wrong so if he loses a dollar and has to spend another dollar, spending two to make five, he’s still up $3. He can be wrong four out of five times and still be in great shape.” – Anthony Robbins on Paul Tudor Jones
“The most important thing is money management, money management, money management. Anybody who is successful will tell you the same thing.” – Marty Schwartz