After an entry the risk/reward ratio quantifies a trades potential for loss size versus the size of possible profits. When backtesting signals the average size of all the losing trades in a system compared to the average size of all the gains gives you the system’s risk/reward ratio based on historical price action.
For discretionary traders, looking at your stop loss versus your profit target for any trade can tell you whether the risk is worth taking the risk on a trade. Most of the time a trade is only viable if there is at least a 1:2 or 1:3 risk to reward ratio based on your trade management plan. The reward should always be a multiple of the stop loss for a good probability of being profitable over the long term.
The higher your reward could potentially be versus your risk, the less your winning percentage has to be to make money. The lower the needed winning percentage the higher the probability of profitability for the trader or system.
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Your risk is established by the location of your stop loss on the price action on the chart. A stop loss should be set at the level that will show you that your trade is not going to work out and it is time to exit while a loss is still small.
Your profit target on entry is the price level you believe that price has a high probability to go if the trade is a winner based on the chart pattern of historical price action. Your maximum reward is where the most potential profit could be achieved and can be set to establish the reward in your ratio.
You can maximize the potential for capturing a big trend by being flexible and leaving your upside uncapped by using a trailing stop to take you out of a winning trade and only exiting when price reverses. A trailing stop can create bigger winning trades and maximum rewards by risking open profits to let your winning trades run. The drawback of using a trailing stop versus a profit target is you will never get out at the top.
To psychologically create a great risk to reward ratio you need to be very patient with winning trades and give them enough room and opportunity to play out for the most benefit. While at the same time having no patience for losing trades and exit the moment you are proven wrong based on price action hitting your stop loss.
If you buy 100 shares of a stock at $100 for a $10,000 position size and your stop loss is at $97 and your profit target is at $109 here are your risk reward dynamics.
- Your risk is $300 if your stop loss is triggered.
- Your reward is $900 if your profit target is reached.
- You risk/reward ratio is 1/3.
- You are risking $300 to make $900.
- With a 1/3 risk to reward ratio you only need a 25% win rate to break even.
- To achieve profitability you have to either tighten you stop losses or make you winners bigger when possible.
Your risk is how much losing trades cost you, your reward is how much winning trades pay you.
Creating good risk/reward ratios with high probability entries through stop losses & letting winners run is the core of all profitable trading.
For a deeper dive into risk management for traders check out my book The Ultimate Trading Risk Management Guide.