Risk-reward ratio

Experienced traders never enter a trade without a clear plan for where they will exit, regardless of whether the trade results in a profit or a loss.

To determine their exit points, they use the risk-reward ratio, which helps them effectively manage capital and minimize losses.

1. What is the risk-reward ratio?
2. Selecting trading opportunities
3. Closing positions

What is the risk-reward ratio?

The risk-reward ratio is a fundamental component of successful trading. It helps traders determine the level of risk they are willing to accept for each trade and the expected profit needed to justify that risk.

This ratio influences two key aspects of daily trading:

• Deciding whether to take a trading opportunity or pass on it

• Determining the exit point to secure a profit or minimize a loss

Selecting trading opportunities

When using the risk-reward ratio, you should only open trades that align with your trading plan.

There is no universal risk-reward ratio that suits every trader. To determine your ideal ratio, consider two key factors: the realistic expected profit per trade and the probability of successful trades. Finding the right balance between these two elements is crucial for long-term profitability.

Risk-reward trading example

If you set a 1:1 ratio, it means your expected profit equals the amount you are risking. For example, if your maximum possible loss is $250, your target profit should also be $250.

In this scenario, you would need a win rate higher than 50% to remain profitable. Since each losing trade cancels out a winning trade, this approach leaves little room for error.

If you use a 1:2 ratio, it means your potential profit is twice the amount you are risking.

In this case, you don’t need to be right in 50% of trades to be profitable. It would take two losing trades to cancel out one winning trade, giving you more flexibility to manage losing streaks and still maintain overall profitability.

Closing positions

To effectively manage risk, it is essential to use stop-loss orders for every trade.

Setting a stop-loss

A stop-loss should be placed at a level where your market prediction would be considered incorrect.

• If you trade based on pullbacks and breakouts, set your stop-loss at the level where a fakeout would be confirmed.

• Another approach is to position your stop-loss just below the last support level (for long trades) or above the last resistance level (for short trades).

• This strategy ensures that if the market moves against you, losses are minimized and your capital remains protected.

Taking profits

Once your stop-loss is in place, the level at which you exit the trade with profit depends on your risk-reward ratio.

• For example, if your risk-reward ratio is 1:2 and your stop-loss is set 20 pips below your entry price, your take-profit target should be set at 40 pips.

Properly setting both stop-loss and take-profit orders ensures a disciplined trading approach, helping to minimize risks while maximizing potential gains.

You may consider adding a take-profit order, which will automatically close your position at a predefined profit level. This order allows you to secure your gains if the market reaches your target, eliminating the need for constant price monitoring.

How much can you risk?

The risk-reward ratio is a crucial tool for effective trading, but on its own, it won’t prevent significant losses if you risk too much on each trade.

As explained in the risk management lesson, allocating too high a percentage of your capital to a single position can quickly deplete your account:

• If you risk 10% of your capital per trade, just ten consecutive losing trades could wipe out your entire account.

• By reducing your risk to 2% per trade, you create a much larger financial buffer to withstand losing streaks and recover from losses.

Proper risk management ensures the long-term sustainability of your trading strategy and helps prevent significant financial setbacks.