How To Use The Reward Risk Ratio When Trading Online?
Let’s say it immediately: the winrate in online trading is completely irrelevant. Lots of traders do focus on the winrate and they don’t get that the winrate doesn’t tell anything about the quality of a system or a trader.
To explain better this concept you can lose also with a 80% or even 90% winrate if those few losers are big enough to kill your winners. Similarly we can have profitable system even if it has a winrate of just 50%, 40% or even 30%. This is possible if you are particularly skilled in letting winners run and cutting losses quickly.
So the winrate it is not particularly relevant. It all comes down to your reward risk ratio (RRR, or reward risk ratio) which is surely the most important metric in online trading. If a trader can master the RRR than it will improve significantly the chances of being profitable.
What are Reward Risk Ratio Myths?
First of all let’s look at some misconceptions around the Reward Risk Ratio so that you can understand why many people are getting this concept wrong before deep diving into the RRR and see how it can be used.
Myth 1: The reward risk ratio is useless
Many online traders say that the reward-risk ratio is useless and this is an absolute non-sense. If you use the RRR with other metrics like the winrate you have one of the most powerful trading tools. If you don’t know the reward risk ratio of a single trade it is basically impossible to trade profitable and we will explain you why.
Myth 2: “Good” vs. “bad” reward risk ratio
We have heard it many time and it is another myth: there is no ‘minimum’ reward risk ratio. Even some very popular online trading books have come up with statements like you need at least RRR of 2:1 or more. A sentence like this doesn’t make any sense especially as it is pronounced without knowing any other trading parameters.
There isn’t a good or bad reward risk ratios. It all depends how you are going to use it as you can even trade profitably with a reward risk ratio of 1:1 or less as we will demonstrate later on in this article.
Myth 3: A bad trade doesn’t improve with a high reward risk ratio
Many times online traders think that by using a wider take profit or a closer stop loss they can improve easily their reward risk ratio and overtime improve their trading performance. We all wish it was that easy but it is definitely not.
If you use a wider take profit it means that you won’t be able to take the profit order easily and possibly this is going to have a negative effect on your winrate. If you set your stop loss closer it will happen that you will prematurely stop a trade and you will come out too early on what was a possible profitable trade.
You have to set your trading rules and follow them as a bad trade doesn’t suddenly become a good one by just hoping to achieve a larger reward:risk ratio.
The Basics – Reward Risk Ratio 101
So what is the reward risk ratio? In simple words is the measure of the distance from your entry to your stop loss and your take profit order and the comparison between the two distances.
How we calculate the Reward Risk Ratio?
Let’s make things easier with one example. Let’s suppose the distance between your entry and stop loss is 50 points and the distance between your entry and your take profit is 100 points. In this case the reward risk ratio is 2:1 as 100/2 is equal 2.
Reward Risk Ratio Formula
RRR = (Take Profit – Entry ) / (Entry – Stop loss)
Step 2: Minimum Winrate
When you have established your reward:risk ratio for your trade you will than be able to calculate the minimum required winrate with the formula below.
This is really important as if you are making traders that have a small RRR you will be in red in the long run even if you think you are doing good trades.
Minimum Winrate Formula
Minimum Winrate = 1 / (1 + Reward:Risk)
So for example if you are entering a trade with a 1:1 reward:risk ratio you have to have a winrate of more than 50% in order to be a profitable trader:
1 / (1+1) = 0.5 = 50%
So this concept it is fundamental to grasp as knowing this formula immediately tells you that you don’t need either a very high winrate or a large reward:risk ratio in order to be a profitable trader. As long as your reward:risk ratio and your historical winrate match than you will get a positive outcome.
How to find a profitable trading strategy?
So let’s now put all the things together and come up with a trading strategy. In the image below we have done a performance simulation where you get a winrate of 50% and a risk of 2.5% per trade. The Reward: Risk Ratio was set at 2:1 on average per trade.
As you can see all the simulations show that all of those outcomes were positive after 500 trades. This is because with a winrate of 50% you only need to get a RRR greater than 1:1 to have a profit. If you have a 2:1 RRR you can have a very profitable trades with a winrate of 50%.
So a good tip here is that if you know that you have a winrate of around 50% you should only look for trades that have 1.5:1 or 2:1 or higher RRR so that you can accelerate your account growth.
Now let’s take a good look at the same strategy with same risk per trade and same winrate. In this case only the RRR was changed as it is now 1:1.
From this analysis we can see that of the 20 simulated outcomes only few of those have generated a positive outcome and most of them were on the red.
This is because if you have a winrate of 50% and you are trading a RRR of 1:1 than the situation will become very volatile and the variance will be massive. With a winrate of 50% as we have seen in the formula you need a RRR greater than 1:1.
So a good tip here is that if you have a winrate of 50% the 1:1 RRR is just the threshold and it is important to add a buffer to the RRR once we know the winrate.