The risk to reward ratio is a representation of the size of the stop loss in a trade compared to the size of the profit target. When many traders are starting out, they are taught that higher risk to reward is good because one win can make up for more losses. While this is true, high risk to reward may not be what it first seems, and chasing it may be stopping you from reaching profitability.
This may be made worse by the rise in readers posting ridiculously high risk to reward trades. 1:25, 1:50, 1:100 trades you see online can make you feel like your 1:2 strategy isn’t good enough. But often there’s more to the story. For a start, lots of these traders have courses to sell so will only be showing trades that make them seem like they are a trader others want to learn from. But after all, anyone can draw up a high risk to reward trade in hindsight.
True Risk To Reward
Some traders do actually hit these trades, but it’s very unlikely that they held full volume for the whole trade. More likely, along the way they take partials, which drastically reduces the true risk to reward of the trade. This is calculated by adding up all of the partials. As you can see, the true risk to reward is much lower than what it first seems. The difference depends on how aggressive a trader takes partials.
Dynamic Risk To Reward
Another problem with extremely high risk to reward trades is dynamic risk to reward. As a trade moves into floating profit, your equity increases. But with high risk to reward trades, you won’t lock in this profit until you take partials or hit your profit target. As I discussed before, taking partials reduces reduces true risk to reward but holding full volume also has a problem. You are risking your floating profit plus your original risk until you reach your profit target.
This means your dynamic risk to reward is changing. For example. if you entered a trade with $1,000 risk and a $10,000 profit target, the original risk to reward is 1:10. But if your trade goes into $5,000 floating profit, you are risking $6,000 in order to make an extra $5,000. Meaning your dynamic risk to reward at that moment is 1:0.83. You could reduce some risk by setting your stop loss to breakeven, but even then the dynamic risk to reward is 1:1. Dynamic risk to reward effects every trade, but the higher the original risk to reward, the higher the floating profits that you will be risking.
Benefits Of Risk To Reward
Now I’ve said a lot against high risk to reward strategies, why can they be beneficial? For a start, risk to reward is a component of profitability. That, and win rate can be used to calculate the profit factor of your strategy.
Average risk to reward multiplied by win percentage, divided by loss percentage = profit factor. A profit factor above 1 is profitable. For example a with a strategy with a profit factor of 1.5, in the long run for every 1$ in gross losses the strategy will have made $1.5 in gross profit. High risk reward is good because it allows a lower win rate strategy to still be profitable.
The win percentage needed to breakeven can be represented in the formula 1 over risk to reward + 1. With a 1:2 risk to reward, the breakeven win rate is 1/3, 33% while with a 1:10 risk to reward, the breakeven win rate is 1/11, 9.1%. This is a benefit of high risk to reward, but doesn’t guarantee profitability. As you increase risk to reward, the profit target gets harder to hit so your win rate will fall too.
The key to profitability is finding a balance between risk to reward and win rate. Your risk to reward could even be lower than 1:1. As long as you have the win rate to support it, no matter what your risk to reward is, if you can stick to your trading plan you are on the road to profitability. Make sure to use soft4x Forex backtester, or TradingView to backtest so that you understand what level of risk to reward works for you.