Using the Risk/Reward Ratio in Trading
The risk/reward ratio is used to assess the profit potential of a trade relative to its loss potential. In order to attain the risk and reward of a trade, both the risk and profit potential of a trade must be defined by the trader. Risk is determined using a stop loss order, where the risk is the price difference between the entry point of the trade and the stop loss order. A profit target is used to establish an exit point should the trade move favorably. The potential profit for the trade is the price difference between the profit target and the entry price.
If a trader buys a stock at $25.60, places a stop loss at $25.50 and a profit target at $25.85, then the risk on the trade is $0.10 ($25.60 - $25.50) and the profit potential is $0.25 ($25.85 - $25.60).
The risk is then compared to the profit to create the ratio: risk/reward = $0.10 / $0.25 = 0.4
If the ratio is great than 1.0, the risk is greater than the profit potential on the trade. If the ratio is less than 1.0, the profit potential is greater than the risk.
Closer Look at the Risk/Reward Ratio
By itself, it appears that low risk/ratios of 0.1 or 0.2 are better, however, that is not necessarily the case. Traders must also consider the odds that their profit target will be reached before their stop loss. You can make any trade look attractive by putting your profit target far away from the entry point, but how often will the market reach that lofty target before reaching the much closer stop loss level?
Therefore, there is a balancing act between taking trades that offer more profit than risk, but where the trade still has a reasonable chance of reaching the target before the stop loss. For most day traders, risk/reward ratios typically fall between 1.0 and 0.25, although there are exceptions. Day traders, swing traders, and investors should shy away from trades where the profit potential is less than what they are putting at risk, for example, a risk/reward greater than 1.0. There are enough favorable opportunities available that there is little reason to take on more risk for less profit.
When establishing the risk/reward for a trade, place the stop loss at a logical place on the chart according to your strategy, then place a logical profit target based on your strategy/analysis. These levels should not be randomly chosen. When the stop loss and profit target locations are established, only then assess the risk/reward of the trade and decide if the trade is worth taking. A common mistake is that traders have a certain risk/reward ratio in mind. For example, they may only want to risk $0.05 to make $0.20 and so they enter the trade anywhere and place a stop loss $0.05 away and a profit target $0.20 away. While this may occasionally work, it is not an ideal way to trade.
To trade effectively, have a trading plan in place that tells you exactly when and where to enter a trade and where to place your stop loss levels and targets under various market conditions. Then have a rule that stipulates that you only take trades that produce a risk/reward ratio of a certain number or lower.
Final Word on the Risk/Reward Ratio
In isolation, it is typically better to take trades that have lower risk/reward ratios, as that means the profit potential outweighs the risk. The risk/reward doesn't need to be very low to be effective, though; anything below 1.0 is likely to produce better results than taking trades with a greater than 1.0 risk/reward ratio. The risk/reward ratio is often used in combination with other risk management ratios, such as the win/loss ratio, which compares the number of winning and losing trades, and the break-even percentage, which gives the number of winning trades that are required to break even.