Putting Risk Reward into PerspectiveMost newbies, and even intermediate traders don't really understand what high risk to reward trades require from themselves and from the market. They think it is something to strive for, and that high RR trades are reserved for the pros. This is far from the truth.
In this video I try to give more perspective to this concept.
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RISK TO REWARD 📚 An Educational Write-up on How to Find ThisIntroduction:
This illustration explains the minimum Risk-To-Reward ratio needed based on your average win-rate while using a fixed % risk amount.
"Risk-To-Reward ratio": The ratio of what you stand to lose compared to win.
"Fixed % Risk": A static % amount of your total account balance at risk per trade.
"Fixed Dollar Risk": A static $ amount at risk per trade. Regardless of account size fluctuations.
"Win-rate": The % out of all trades that are winners.
Steps:
1. Before being able to determine what Risk-To-Reward is acceptable to use, you will need to create a baseline measurement of your strategy's performance.
2. To create this baseline, you will need to backtest your strategy and obtain its current average win-rate.
3. This can be done using your pre-determined entry logic with a fixed stop-loss/take-profit offset amount.
(Adjusting your entry logic prior to finishing a round of backtesting may produce skewed results. Do not "cherry-pick" trades as that will lead to false results.)
4. Based on the resulting average win-rate you can then find the minimum Risk-To-Reward ratio you should be using.
5. Backtest again using the more optimal Risk-To-Reward ratio and repeat this step until the most optimal backtest results are obtained.
Here is the formula for determining your Average win-rate after you have tallied the wins/losses of your backtest:
#W = Number of winning trades
#L = Number of losing trades
(#W / (#W + #L)) * 100 = your average win rate %
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Introduction to Fixed Dollar Risk:
We have found it common for people to use the logic of fixed dollar risk amounts when calculating win-rates needed to break even, but then to use a fixed % risk in practice.
This simple-to-make mistake can lead to account erosion over time due to the way compounding works.
The fixed dollar approach uses relatively simple math for breaking even as shown below.
Example:
3 losing trades followed by 1 winning trade using 1:3 risk-to-reward achieves breakeven (ignoring trading fees and slippage)
This risk-to-reward ratio itself implies the win-rate needed (lose $100 three times, win $300 once, you break even).
The fixed dollar amount risk doesn't deal with compounding. As such, its logic cannot be used for fixed %.
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Using Fixed Percentage Risk:
Fixed % uses a more complicated and less apparent method for calculating how to break even. As shown in our illustration, if you take three losses in a row you won’t break even after your next win.
Fixed % is always dealing with the same % of your current balance. So as your balance decreases, the total dollar amount risked is less, and the total dollar amount gained with each win is reduced.
Thus, strings of losses require additional wins compared to the fixed dollar approach.
The fixed % method ensures against account erosion by showing the minimum win-rate needed to use each risk-to-reward ratio.
MATH NOTE: We used a simplified method for finding the minimum win-rate to make this useful and generally applicable. Our method is based on a given risk-to-reward ratio and assumes the max number of losses in a row to produce a minimum win-rate, it does not factor in all different possible loss strings and their probability.
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WHY USE FIXED % !?:
The question one will have at this point is, "Why to use fixed % if it is so F'ing complicated!?"
The answer to that is simple. Despite being more complicated, fixed % is actually objectively better by almost every other measure.
With fixed % you generally perform better than fixed dollar during strings of losses and wins. As with fixed %, you lose less as you go down (because you only ever lose 1% of your balance), and you gain more as you go up (because of your winnings compounding).
Not only that, but you also perform better even when losses and wins are more scattered, as you can see on the chart below.
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Conclusion:
Fixed % is more complicated than fixed dollar... to say the least.
However , it is none-the-less superior in most instances.
Use the logic above while using fixed % risk, since if you use fixed dollar logic but use fixed % in practice you will underperform your theoretical results.
If there are any major flaws in our logic/approach please let us know in the comments as of course, we are looking to provide as accurate instructional writeups as possible!
Bankroll and Risk Management, Risk to Reward Ratio - EDUCATIONALIn this example I am showing you how important is RIsk Management in your trading system.
You could be the most talented trader in the world with a natural eye for investment opportunities, and still blow your account with one bad call without proper risk management. No matter how good you are, or how experienced you are, you’re still going to incur losses. Even the best traders in the world suffer losing trades - it’s part and parcel of trading. That’s why risk management is so important to your trading.
One way that you could strike the right balance between reward and risk is to stick to a reward:risk ratio such as 2:1 or even 3:1, where your targeted profits are always double that of your maximum losses. So even if you suffer three losing trades, you’ll only need two profitable ones to ensure your total profits outnumber your losses if you stick to this reward:risk ratio. Although it’s not a general rule to follow, it can help you to visualise a specific approach to risk management.
"It's not important whether you are right or wrong. It's about how much money you make."
That means that you can still win 4/6 trade and you are still loosing money.
In the example showed you can see that investing different amount of money in each trade can drive to a negative ROI even if yours winning rate is over 66% .
Education post 20/100 – How to trade better using Risk-Reward?Education post 20/100 – How to trade better using good Risk-Reward Ratio?
Day Trading Win-Loss Ratio
Most day traders focus on the win-rate or win/loss ratio. The allure is to eventually reach that stage where nearly all their trades are winners. Don't be fooled, having a high win rate doesn't mean you'll be a successful trader or even a profitable one.
Your win rate is how many trades you win out of all your trades. For example, if you make five trades a day, and win three, your daily win rate is 3/5=0.6, or 60%. If there are 20 trading days in the month, and you won 60 out of 100 trades, your monthly win rate is 60%.
The win-loss ratio is your wins divided by your losses. In the example, assume for simplicity 60 trades were winners and 40 were losers (100 - 60). This assumes there were no "flat" trades. The win-loss ratio is 60/40=1.5. This means you are winning 50% of the time more than you are losing. A win-loss ratio above 1.0, or a win rate above 50%, is favorable, but it isn't the only story.
Day Trading Risk-Reward Ratios
A risk-reward ratio is how much you expect to make on a trade, relative to how much you're willing to lose.
Day traders want to be in and out of the market quickly, taking advantage of short-term patterns and trade signals. This typically means each trade will have a stop loss attached to it. The stop-loss determines how many cents, ticks or pips you are willing to risk in a stock, future or forex pair respectively.
Assume you are willing to risk $0.10 on stock XZYZ, buying it at $10.00 and placing a stop loss at $9.90.
Your risk is fixed at $0.10 (assuming no slippage), but you must be compensated for taking this risk with a potential profit as well. Your profit target establishes your expected payoff.
Assume, based on your analysis or trading strategy that you believe the price will reach $10.20, at which point you will take profit, resulting in a $0.20 gain.
Your potential reward is therefore twice as large as your potential risk. Your risk/reward ratio is $0.10/$0.20=0.5; in other words, your risk is half of your potential gain.
If you take a profit at $10.10, your potential profit and risk are both $0.10, so the risk/reward ratio is $0.10/$0.10=1.0. If you take profit at $10.05 your potential risk is $0.10 but your reward is only $0.05. In this case, the risk/reward increases to 2.0 showing that you are risking more to make less.
Balancing Win Rate and Risk-Reward in Day Trading
Day traders must strike a balance between win rate and risk-reward. A high win rate means nothing if the risk-reward is very high, and great risk-reward ratio may mean nothing if the win rate is very low.
Consider these guidelines when you start coming up with a day trading strategy or are looking to improve your day trading results:
A higher win rate means your risk-reward can be higher. You can still be profitable with a 60% win rate and a risk reward of 1.0. You'll be more profitable with a 60% rate and a risk-reward below 1.0.
A low win rate, 50% or below, requires winners to be larger than losers in order for you to be profitable. You can still be profitable with a 40% win rate if risk/reward is below 0.6 (excluding commissions). Ideally, if your win rate is below 50% strive for a risk/reward below 0.65, with the risk-reward decreasing the more the win rate drops. The more you lose, the bigger your winners must be when you do win.
Day Trading at Your Peak Ratios
Since day traders trade every day in all types of conditions (see How Often to Trade), most day traders should seek out a strategy that allows them to win between 50% and 70% of the time. Winning more than that becomes increasingly difficult with only minor additional payoff.
This win rate allows for some flexibility in the risk-reward ratio. Strive to make a bit more on winners than you do on losers; ideally, wins should be about 1.5 times greater than risk - if risking $0.10 try to make at least $0.15. This risk/reward ratio is 0.67. Keep the risk/reward below 1.0, that way even if you have an off day, only winning 40% of your trades, you can likely still pull out a daily profit.
Your ideal mix will depend on your trading style. But you don't need a very high win rate or a super low risk/reward ratio to be successful. Strike a balance, and strive for consistency.
