Risk Vs. Reward Ratios

The realisation of long-term profitability is the primary goal of every trader and investor. There are many different philosophies regarding the “correct” way to achieve this objective, a vast majority of which involve minimising losses while maximising returns. Perhaps the most basic method of defining capital allocation is through the use of a risk vs reward ratio.

Calculating Risk Vs Reward

The risk vs reward ratio (R/R) is a direct comparison of possible loss and potential gain. Calculating an R/R is relatively self explanatory:

  • Risk vs Reward Ratio: R/R = (Initial capital risk) / (Potential capital return)

Depending on the type of financial instrument being traded, risk and reward may be quantified using various numbers of ticks, pips or points. For instance, take the following trade scenario in the forex market:

  • A new currency trader decides to buy one standard lot of EUR/USD at 1.08734
  • Technicals show an area of support at 1.08725 and upside resistance at 1.08775
  • The trader sets an initial stop loss one pip below support at 1.08724 and the initial profit target just beneath upside resistance at 1.08774
  • The trade’s R/R in terms of pips and hard currency:
    • Pips: An initial stop of 10 pips and profit target of 40 pips.
      • Risk vs Reward is 10 / 40 = 1:4 ratio
    • Currency: The leverage placed on the trade is one standard lot (100,000 units) of EUR/USD, a value equal to US$10 per/pip.
      • Initial risk is 10 pips * US$10 per/pip = US$100.
      • Potential reward is 40 pips * US$10 per/pip = US$400.
      • Risk vs Reward is US$100 / US$400 = 1:4 ratio

In the above example, the risk vs reward is 1:4, meaning that for every pip or dollar risked, four pips or dollars potentially comeback. The R/R is also commonly expressed as its inverse, reward to risk. In this case, the reward to risk is said to be 4:1, meaning the profit is 4 times the loss. Both ratios perform the same function: relate the amount of a possible loss to a potential gain.

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Applications Of Risk Vs Reward

The concept of risk vs reward is fairly straightforward, yet it is a topic of ongoing debate. Many market participants champion the philosophy of taking trades that have large payoffs, defined by low initial risks and high potential rewards. On the other hand, some trading methods promote taking smaller profits that are more readily available regardless of the R/R. No matter which school of thought one subscribes to, the primary goal is to realise profit over the long-run. In order to accomplish this, total gains must eclipse total losses.

A useful way of incorporating R/R into a trade’s valuation is through calculating a breakeven percentage (BE). BE is the portion of the time that a strategy must be successful to realise a net zero gain or loss.

The formula for BE is:

  • BE = (Initial Risk / (Potential Profit + Initial Risk)) *100

Assuming a currency trader is mulling a EUR/USD trade with a 1:4 R/R, using a 10 pip initial stop and 40 pip profit target, the BE is:

  • BE: (10 / (40 + 10)) * 100 = 20%

The BE for the trade is 20%, meaning that in order to not lose any money, the trade must be successful at least 20% of the time. If the 20% value is too high for a given strategy, then altering initial risk with potential reward may be necessary to ensure profitability.

Summary

Applying the concept of risk vs reward to real-world trading can be a challenge. The marketplace is a dynamic atmosphere that is capable of changing in an instant, with optimal values for risk and reward often fluctuating on a trade-by-trade basis.

However, if one is able to identify a trade’s initial risk and potential reward, then informed decisions can be made in regards to trade execution and long-term viability.

Any opinions, news, research, analyses, prices, other information, or links to third-party sites are provided as general market commentary and do not constitute investment advice. FXCM will not accept liability for any loss or damage including, without limitation, to any loss of profit which may arise directly or indirectly from use of or reliance on such information.