Follow this “trading wisdom” at your peril

There are a few pieces of perceived market “wisdom” that really get my back up.

One of them is: “Cut your losses and run your profits.” (I’ll save my rant on that one for another day.)

Today’s bug-bear is the trading “wisdom” that you should only follow trades with a risk-reward ratio of at least 2:1. (i.e. you should have a potential reward of at least £2 for every £1 risked.)

In my opinion, this is foolhardy – rather like standing at the racecourse and always throwing your money at the 50/1 outsider, because you won’t make enough return on the favourite that’s just raced home at 3/2 – again!

Understanding risk-reward

Risk-reward is an extremely important concept in trading. Too many traders don’t fully understand it, and blindly follow advice about 2:1 ratios – at their peril.

However, if you can get a grip on your risk-reward factor, you can effectively use it to your advantage in trading.

The “risk” part is how much you would expect to lose if your trade is unsuccessful.

The “reward” is how much you expect to gain if your trade is successful.

So, the risk-reward ratio is one of these figures against the other. Now – just to keep us on our toes – the standard way of writing this ratio is backwards! I.e. if you’re risking £1 to make £2, your risk-reward ration is 2:1.

How to calculate your risk-reward ratio

To work out what your risk-reward is on any given trade, ask yourself these two questions:

1. If I’m correct and the trade wins, how much do I expect to earn?

2. If I’m wrong and the trade loses, how much do I expect to lose?

Let’s say that I see a great opportunity on the GBP/EUR at 1.195, and I believe that the currency will rise 1.200, offering 50 pips profit. To give my trade room to breathe, I put my stop loss below the previous day’s low, at 1.185. That means that my stop is 50 pips away from my entry point.

So, my potential reward is 50 pips, and my potential risk is 50 pips – 50/50. That gives me a risk-reward ratio of 1:1.

Let’s take another example …

This time, I’ve seen a great play on the FTSE, at 5510, and I think that the market will rise by 80 points to 5590. There’s strong resistance around 5500, so I put my stop loss just below the resistance at 5490.

This time, my potential reward is 80 points, but my potential risk is just 20 points – 80/20. So my risk-reward ratio is 4:1.

Putting risk-reward into perspective

The important thing to remember with risk-reward ratios, is that they tell us nothing about profitability without one extra crucial piece of information …

… probability.

Probability tells you how often your trade is successful. A 20% success rate, tells us that for every 100 trades you place, you expect 20 of them to be profitable. An 80% success rate means that for every 100 trades you place, you expect 80 of them to be profitable.

You can have yourself a trade with a 4:1 risk-reward ratio, but if it only wins 20% of the time, it won’t take you very far.

However, if you have a trade with a risk-reward ratio of 1:3 (i.e., you’re risking £30 for every £10 potential winnings), but it has success rate of 80%, you’ll be profitable.

As you can see here, all the well-balanced risk-reward ratios in the world, won’t make your trading successful, unless you have carefully balanced it with probability.

The big 2:1 con

Having explained why the magic 2:1 risk-reward ratio isn’t worth the paper it’s written on without it’s corresponding probability … I’d like to go on to explain why I’d rather have a 1:2 ratio than a 7:1 …

Let’s look at these examples:

Trader A has a 7:1 risk-reward ratio, combined with a success rate of 15%. For every £1 he risks, his potential reward is £7. And for every 100 trades he places, he should be winning 15 of them and losing 85. The net result is: for every £85 he loses, he should be rewarded by £105 – a net of £20.

However, bear in mind, that Trader A will be losing 85% of his trades. Add to that a nasty run of losers, and he can very quickly feel completely disheartened. And, if he misses out on one of his rare winning trades (by making a mistake or missing a signal) – he’ll be seriously set back.

Trader B, on the other hand has a 1:3 risk-reward ratio. So, Trader B will win just £1 for every £3 risked. This would be thrown out of the trading books by some – “Just too risky” they would tell you.

However, if Trader B can combine it with a probability of 80%, I believe that more often than not, he’ll beat Trader A.

Out of every 100 trades, Trader B expects to win 80 and lose 20, so the net result is that for every £60 he loses, he should be rewarded by £80. – a net of £20.

On paper, it looks like Trader A and Trader B are pretty evenly matched on profitability. However, there are few traders I know who can take a 15% win rate with the kind of disconnected attitude it requires. If you’re losing 75 out of every 100 trades – it’s going to be hard to maintain a positive attitude to your trading. Add to that a bad run (we all get them) – and I expect that most of us would lose faith in our trading strategy altogether.

That’s why I’d always recommend a strategy with a high success rate combined with a low risk-reward ratio over a strategy with a great risk-reward ratio and a low win rate.

Quite simply – it’s just better suited to human nature.

Letting the tail wag the dog

There’s another problem that arises if we get too hung up on risk-reward ratios. Let’s go back to that trade of mine on the GBP/EUR …

This time, just before I place my trade I remember that I read somewhere (possibly in “Trading for Dummies”) that my risk-reward ratio shouldn’t be lower than 2:1.

What can I do?

Well, many traders will “fiddle” the trade to fit this philosophy.

Now, I’ll still enter at 1.195, with a target of 1.200 (50 pips potential reward), but this time, rather than setting my stop loss at the previous day’s low, instead I’m setting it at 1.1825 (just 25 pips risk).

This time, my potential reward is 50 pips, and my potential risk is 25 pips – 50/25. Which gives me my tidy risk-reward ratio of 2:1.

I may be following “perceived wisdom”, but I’m running a serious risk of getting bumped out of my trade by a little market “noise”.

And that’s where we see the shortcomings of risk-reward ratios – they simply can’t give us the whole picture of the risks involved …

– they can’t factor in the added risk involved in an inappropriately placed stop loss or profit target.

– they can’t factor in the benefits of reducing your risk in other ways (like diversification and hedging).

– and, of course, they don’t give any information about the success rates of a trade.

Testing your limits

The important thing with risk-reward ratios is to view them as part of the whole profitability picture, and to make a judgement on the kind of success rate and return you expect from your trading.

If you can deal with interminably long losing runs (as long as you get profitability in the end) then you’re made of sterner stuff than I am! As with many aspects of trading, understanding your own limitations is all part of the process.