How to apply Risk Reward Ratio to your Trade

Although at a first glance it seems pretty simple and straight forward, applying Risk/Reward Ratio to your trade takes some serious homework and lots of fine tuning to achieve good results.

First to explain what is actually Risk/Reward Ratio in Trading :

It is a ratio between your risk (how much are you ready to lose) vs Reward ( how much you want to win )

It all starts from there…

But it is not as simple as one might think , and I am going to give you here not only some rules, but examples as well.

To be able to find the R/R that suits your needs, trading style, strategy and the system you use you have to start from the system.

You have to do a thorough back testing of your System.

Find out the following:

How many winning trades it makes for as long as you can go back in time
How many losing trades
What is an average pull back from your entry level
What is an average Profit it makes in any given trade

Now you will get a first important info on your trading : Probability

How to apply Risk Reward Ratio to your Trade

So how to calculate a Probability of your system :

You had 140 winning trades and 60 losing one’s – 200 trades in total
Divide (140:200) x 100 =70 – your Probability is in your favour and it is 70%
Do not start immediately with the idea that from 10 trades you’ll be winning 7 – it might not happen like that at all…you might have 7 losing trades in a row , followed by 20 winning trades…or anything in between.
This is a Probability of your system on the long run

Once you determine that your system gives positive results , you move to the R/R

For Risk – Reward to be on the safe side, it has to be at least 1:1,5 , but what you are looking for is over 1:2

What does that mean :

R/R 1:2 means that on every dollar you risk you expect 2 dollars of profit
In case your Probability is 50% for example – you lose 50$ and win 100$
As Probability is higher , your chances grow exponentially

But pure math is not enough , as you cannot go just with your wishes – you have to face the reality

This is where your back testing comes to play:

You determine the real outcome of your system’s trades and apply it to your R/R

Example:

140 winning trades – 60 losing ones
Average pull back from your entry point is 5 pips
Average Profit of any given winning trade is 20 pips

Based on this, you first determine where your stop loss should be

You go with 8-10 pips for stop loss ( so a bit more than your average pull back from the entry level)
To make this easier to calculate we go with 10 pips stop loss

As your average profit is 20 pips we got the following:

10 pips stop / 20 pips profit target = R/R 1:2
With a Probability established at 70% , on 100 trades you are looking at the following :
Loss 300 pips / Profit 1.400 pips
In the case of higher probability, as I said earlier already it grows significantly.

I have to emphasise that you MUST do your homework properly – back testing must be realistic and without moments like : oh I would never bought it here , or this one I would skip….or my God I would take this trade no matter what…

How to apply Risk Reward Ratio to your Trade