Risk to Reward (R:R)
Risk-to-reward is one of the most important factors to consider as a trader. It defines how much you are willing to lose and how much you hope to gain in any given trade.
Your risk for any trade is the distance from your entry to your stop-loss and your reward for any trade is the distance from your entry to your take profit.
A 1:1 risk-to-reward means you are risking the same amount of money you are hoping to gain, such as risking $100 to make $100. A 1:2 risk-to-reward means you are risking half as much as you hope to gain, such as risking $100 to make $200.
This ratio is crucially important because it will determine how effective your trading needs to be profitable. At a 1:1, you would need to win more than 50% of all your trades to be profitable, but at 1:2, you only need to win a little more than 33%. That percentage, naturally, falls even lower the higher your risk-to-reward ratio goes, so it’s very possible a strategy with even just a 25% win rate is profitable because it returns a 1:4 risk-to-reward when it’s successful.
Most traders assume you have to win all or most of your trades to make it as a trader, but many, perhaps even most traders, lose the majority of their trades. The key to success is often as simple as keeping your wins larger than your losses.
That said, arbitrarily increasing your risk-to-reward won’t increase the likelihood of success. You still need to be data-driven and have a strategy with a demonstrable win rate and achievable risk-to-reward. With that information, you can know if a strategy is or is not profitable. As alluded to, even seemingly bad strategies can be profitable because they have big winners when they work, so you’ll always want to keep risk-to-reward in mind whenever you are placing a trade.
Risk-to-reward ratios allow you to approach your trading mathematically and back your strategies with concrete numbers. If you know your win rate, you know what risk-to-reward you have to aim for, and if you know the risk-to-reward you can expect from your strategy, you know what your win rate needs to be to make money.