How useful is the risk reward ratio?

Risk to reward ratio is not only a way of money management but the main way to realize profits in trading. Many traders put way too much emphasis on the winrate and do not understand that a winrate does not tell you anything about the quality of a system or a trader.

Risk reward ratio is the “holy grail” of trading.  When you know the risk reward ratio for your trading system, you can easily calculate the minimum required winrate.

Take a look at the table below;

Minimum Winrate = 1 / (1 + Reward:Risk)

Positive risk reward means more return on your investment as shown in the table; the advantage here is that you can afford to take stop loss hits more than you think. In fact, it’s possible to lose more than ½ your trades and still turn over a profit if you have the correct risk reward.

This is because your winning trades make up for any losing trades you may have accumulated, plus the leftover profit on top. So even with losing trades you can still build up your equity curve.

A negative risk reward ratio means you are risking more and making too little. This is the worst way to make money in any business. In this case, you must have a very high win rate to stay profitable. This is one of the reasons most forex traders lose money.

Ideally, we want to look for trade setups with a risk / reward of at least 1 to 2, by getting a risk / reward of 1:2 on every trade setup, we can lose on well over 50% of our trades and STILL make money. ; if you execute it properly you can make consistent money over a period of time.

Risk reward ratio is the most important metric in trading and a trader who understands it can greatly improve his/her chances of becoming profitable. Take a look at the graph below;

If you understand this connection, you quickly see that you neither need an extremely high winrate nor a large reward:risk ratio to make money as a trader. As long as your reward:risk ratio and your historical winrate match, your trading will provide a positive expectancy.

The lesson to be learned here is that you can make still money in the forex markets even if you lose far more trades than you win if you keep a positive risk reward ratio.

 

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