Risk-reward ratio
The reward to risk ratio compares the possible gain with the possible loss. Together with the win rate, it decides whether a strategy can work at all.
Learning objective: After this lesson you can calculate the reward to risk ratio of a position and judge whether a strategy is viable.
If you can win two euros and risk one, your ratio is two to one. That means you can be wrong more often than right and still make money.
The Required Win Rate
At two to one, a win rate of just over 33 percent is enough to break even. At one to one you need over 50 percent. At one to two, just under 67 percent.
Why Win Rate Alone Falls Short
So the win rate alone tells you nothing. Even someone who's right nine times out of ten can lose if the one failure eats up all nine gains. That happens more often than you'd think, especially with people who take profits quickly and let losses run.
Fixing the Ratio in Advance
It's important that the ratio is fixed before you enter. Anyone who pushes the target up afterwards because things are going well, or the stop down because things are going badly, no longer has a ratio at all.
You work out the minimum win rate you need not to lose like this: one divided by (one plus the ratio). At three to one that's 25 percent, at one to one 50 percent, at one to two just under 67 percent. So win rate and ratio only make a statement together.
How the Two Connect
In practice the two are linked. Distant price targets are reached less often. A high ratio therefore almost always comes with a lower win rate. You can't simply improve a strategy by setting the target further away. You'll just hit it less often.
Planned Versus Actual
Also watch the difference between the planned and the actual ratio. Taking profits earlier than planned shortens the winning side. Losses can turn out bigger than planned because of slippage and price gaps. The actual ratio is therefore almost always below the planned one, and you have to allow for that when judging a strategy.
Summary
- The win rate only says something together with the ratio.
- The required win rate is one divided by (one plus the ratio).
- The actual ratio is almost always below the planned one.
Did you get it?
What win rate does a three to one ratio need to break even?
25 percent, because 1 divided by (1 plus 3) is 0.25.
Why doesn't a higher price target automatically make a strategy better?
Because distant targets are reached less often and the win rate falls accordingly.
Why is the actual ratio below the planned one?
Because profits are often taken too early and losses can be bigger due to slippage and price gaps.
Check your understanding
Your task
You enter at $50, place the stop at $47 and the target at $59. Calculate the reward to risk ratio and the minimum hit rate you need to break even. Then write down how both change if you move the target to $56.
Related
- Win rate and expected valueStage 3
- LeverageStage 3
- The one-percent ruleStage 3
- Matching questions for this stageQuestions
- Position-size calculatorCalculators
- Break-even calculatorCalculators