And How Can You Use It To Be A Better Trader?
By Your Trading Mentor,
Trading Angel
Risk to reward ratio (RRR) is a commonly used metric in trading that measures the potential profit of a trade relative to its potential loss. The ratio compares the amount of risk taken on a trade (i.e., the potential loss) to the potential reward of the trade (i.e., the potential profit).
A risk to reward ratio of 1:2 means that the potential profit of a trade is twice the amount of the potential loss. For example, if a trader is willing to risk £100 on a trade, they would be looking for a potential profit of £200 or more, resulting in a 1:2 risk to reward ratio.
A good risk to reward ratio is generally considered to be at least 1:2 or higher, meaning that the potential profit is at least twice the potential loss. This is because a higher risk to reward ratio means that a trader can potentially make a profit even if they are only correct on a relatively small percentage of their trades.
A risk to reward ratio can be calculated for any trading strategy or individual trade, and is an important aspect of risk management. By setting a target risk to reward ratio for each trade, a trader can better manage their risk and ensure that they are only taking trades with a high potential payoff relative to the potential risk.
One of my personal favourite ways to think about a risk to reward ratio before placing any trade is to ask yourself the question, (on a RRR of 1:10 for example) would I give £1 for the potential to gain £10 knowing I had a 50% chance of losing the £1 for good? In this example my clear and honest answer is YES that’s a great offer, law of averages says I can lose a couple times and eventually I should make a win that covers the loses. But if I was to say would I give £5 to potentially win £6 with a 50% chance of losing my £5 for good, then the potential win no longer seems worth it as I would have to know I was going to win a disproportionate amount of times overall in order to definitely be up.
Another way that I like to use RRR in my personal trading is to stop me from making impulsive or FOMO trades. Before any trade I place I ask myself the question ‘Does this trade have a good risk to reward ratio?’ And if I can’t honestly and easily answer YES then I probably don’t have a trade which is worth taking and I’m probably just looking for an excuse to trade rather then actually having a great trade set up in front of me.
So now we know what risk to reward ratio or RRR is, let’s have a look at all the different ways it can be used to make you a better trader.
How can you use RRR to be a better trader?
Using your risk to reward ratio effectively can help you become a better trader in several ways:
1. Better risk management: By setting a specific risk to reward ratio for each trade, you can better manage your risk. This means you can calculate the potential loss upfront and determine if it is worth taking the trade. A good risk to reward ratio helps you to avoid trades with a low potential reward relative to the potential risk.
The risk to reward ratio is key to risk management in trading because it helps traders to manage their trades effectively by limiting potential losses and maximising potential gains. Here are some reasons why a good risk to reward ratio is important for risk management in trading:
Limits potential losses: By setting a specific risk to reward ratio for each trade, traders can limit the potential losses they could incur on a trade. This means that even if the trade is not successful, the trader knows exactly how much they will lose and can plan accordingly.
Maximises potential gains: A good risk to reward ratio allows traders to maximise their potential gains on a trade. By setting a target for the potential profit and ensuring that it is significantly higher than the potential loss, traders can make more money on their winning trades than they lose on their losing trades.
Helps to determine trade size: A risk to reward ratio can also help traders to determine the appropriate trade size for each trade. By factoring in the potential loss and potential profit, traders can calculate the appropriate position size that aligns with their risk management strategy.
Promotes consistency: A consistent risk to reward ratio helps to promote consistency in a trader’s approach to trading. This consistency enables traders to have a more structured trading plan, which can help them to avoid impulsive or emotional trading decisions.
Increases trading confidence: A good risk to reward ratio can also increase a trader’s confidence in their trading strategy. By knowing that their potential losses are limited and their potential gains are maximised, traders can approach their trades with more confidence and a clearer mindset.
The risk to reward ratio is key to risk management in trading because it helps traders to limit potential losses, maximise potential gains, determine trade size, promote consistency, and increase trading confidence.
2. Improved profitability: A higher risk to reward ratio can improve your profitability over time. Even if you are only correct on a relatively small percentage of your trades, a good risk to reward ratio ensures that you make more profit on your winning trades than you lose on your losing trades.
The risk to reward ratio is the ratio of the potential profit on a trade compared to the potential loss. For example, if you enter a trade with a potential profit of £100 and a potential loss of £50, your risk to reward ratio would be 1:2.
A good risk to reward ratio is typically considered to be at least 1:2 or higher, meaning that the potential profit is at least twice the potential loss. By having a good risk to reward ratio, you can limit your losses while maximising your potential gains.
When you have a good risk to reward ratio, you can enter trades with a higher degree of confidence, knowing that even if some trades are losers, your winners will more than make up for them. This can help you to avoid overtrading and chasing losses, which can be detrimental to your profitability.
Overall, a good risk to reward ratio can be a key factor in successful trading by helping you to manage your risk and maximise your potential rewards.
3. Consistency: A consistent risk to reward ratio helps to promote consistency in your trading approach. This consistency enables you to have a more structured trading plan, which can help you to avoid impulsive or emotional trading decisions.
When you have a good risk to reward ratio, you have a predefined ratio of potential profit to potential loss for each trade. This helps you to set clear and consistent trading rules that you can follow regardless of market conditions or emotions.
By having a clear risk to reward ratio, you can more easily manage your trades and avoid making impulsive decisions. For example, if a trade is not meeting your predefined risk to reward ratio, you can exit the trade without hesitation and move on to the next opportunity.
Additionally, having a good risk to reward ratio can help you to maintain discipline in your trading and avoid overtrading. By only taking trades that meet your predefined risk to reward ratio, you can avoid taking unnecessary risks and focus on high-quality trades that have the potential for a favourable outcome.
Overall, a good risk to reward ratio can help you to stay consistent in your trading by providing a clear and consistent framework for managing your trades and reducing emotional decision-making. This can help you to achieve long-term success in the markets.
4. Better decision making: When you have a specific risk to reward ratio in mind for each trade, you are more likely to make better trading decisions. You will be less likely to take trades that do not meet your criteria, and you will be more disciplined in your approach to trading.
Your risk to reward ratio can help you make better trading decisions by providing a clear framework for evaluating potential trades and managing risk.
When you have a predetermined risk to reward ratio in place, you can use it to evaluate potential trades and determine whether they are worth taking. For example, if a trade has a potential reward of £200 and a potential risk of £100, and your minimum risk to reward ratio is 1:2, you would not take the trade because the potential reward is not at least twice the potential risk.
By using your risk to reward ratio to evaluate potential trades, you can avoid taking unnecessary risks and focus on trades that have a high potential for a favourable outcome. This can help you to achieve better results in the long run.
Additionally, your risk to reward ratio can help you to manage risk more effectively. By limiting your potential losses to a predetermined amount, you can avoid taking on too much risk in any one trade. This can help you to protect your trading capital and avoid large drawdowns.
In summary, your risk to reward ratio can help you make better trading decisions by providing a clear framework for evaluating potential trades and managing risk. By using your risk to reward ratio in your trading, you can focus on high-quality trades with a favourable risk to reward ratio and protect your trading capital from excessive risk.
5. Enhance your trading strategy: By evaluating your risk to reward ratio, you can determine if your trading strategy is effective. If you consistently achieve a high risk to reward ratio, it may be a sign that your strategy is working well. If you consistently achieve a low risk to reward ratio, you may need to re-evaluate your strategy and make adjustments.
A good risk to reward ratio can help to enhance your trading strategy by providing a framework for identifying high-quality trading opportunities and managing risk effectively.
When you have a good risk to reward ratio, you can focus on taking trades that have a high potential for a favourable outcome. By only taking trades that meet your minimum risk to reward ratio, you can avoid taking unnecessary risks and focus on trades with a high potential for profit.
A good risk to reward ratio can also help you to manage risk more effectively. By limiting your potential losses to a predetermined amount, you can minimise the impact of losing trades on your trading account. This can help you to avoid large drawdowns and protect your trading capital.
Additionally, a good risk to reward ratio can help you to maintain discipline in your trading. By having a clear framework for evaluating trades and managing risk, you can avoid making impulsive decisions based on emotions or market noise.
Overall, a good risk to reward ratio can help to enhance your trading strategy by providing a clear framework for identifying high-quality trading opportunities and managing risk effectively. By using a risk to reward ratio in your trading strategy, you can focus on trades with a high potential for profit while minimising risk and protecting your trading capital.
In summary, using your risk to reward ratio effectively can help you to better manage your risk, improve your profitability, and become a more disciplined and consistent trader. Before you place any trade, remember to ask yourself the quick question ‘Do I have a good risotto reward ratio?’ And if the answer isn’t a definite YES then you are probably looking at a weak trade which you should consider sitting out of.
Until next time, Happy Trading!
Love From, Your Trading Mentor,
Trading Angel x