The power of understanding risk and reward

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Traders who understand and apply the concept of risk versus reward in their trading systems are able to develop more efficient trading systems, scale up their trading ideas as their capital allows, and most importantly, trade free of the emotional limitations that plague many amateur traders. Let’s take a look at this critical concept and how you can start using it to better your current and future trading systems.

In search of the Holy Grail

Expectations are a powerful thing and unfortunately, many trading related articles paint the illusion of the fast road to riches and incredible wealth by following a simple red line crossing above the green line. Often the expectation is set in place that the system you are about to purchase, the Expert Advisor (EA) you are about to download or the trading educator providing their ‘life’s work’ is going to be the Holy Grail, finally providing you with enough profits to say goodbye to the daily 9-to-5 grind. In reality, there is no Holy Grail when it comes to trading systems, but instead, successful trading is a combination of consistently identifying sensible risk reward opportunities with persistence and discipline.

What is the risk reward ratio?

In its most basic form, the risk reward ratio is exactly what it says on the box. It is the amount of potential reward, relative to the risk you take on. In the table below I’ve listed the various trading instruments with hypothetical stop loss and profit taking levels and the risk reward levels that these generate. By way of example, you can see the risk reward ratio is a function of the size of the stop versus the size of the potential reward.

Time frame Entry level Stop level Profit target Risk:Reward
Telstra Short 5.50 5.25 ($0.25) 5.75 ($0.25) 1:1
Aus200 Index Short 5400 5350 (50 points) 5500 (100 points) 1:2
S&P500 Index Intraday 1995.50 1993.5 (2 points) 1999.5 (4 points) 1:2
Aussie Dollar Medium 0.9000 0.8900 (100 pips) 0.9300 (300 pips) 1:3
Gold Long 1180 1100 ($80) 1400 ($220) 1:2.75

 

Risk reward levels can be applied to all time frames across any asset class and can even be used for other investments as well – such as managed funds, property or business – but today we’ll be focused on applying this to our trading.

How do you calculate the risk reward for potential trades?

Calculating your risk reward is relatively simple and is often done using technical levels on your chart, such as support/resistance levels, Fibonacci, Average True Range (ATR), Ichi Moku and price projection based on chart patterns. While not exact, they do provide a method to determine the potential risk reward on your upcoming trading opportunities, allowing you to focus on those with the highest potential.

Three ways to take advantage of the risk reward ratio in your trading.

  1. Only trade opportunities that meet your risk reward levels and are within your tolerance for risk

Ultimately you need to understand that you control when you pull the trigger to execute a trade, which means you are responsible for each trade you take. For the savvy trader, this is good news. You have the flexibility to take trades that meet your criteria and more importantly, reject those that aren’t up to scratch. Set a benchmark for trades you will accept, such as only trading those opportunities with a 1:2 or 1:3 risk reward ratio.

  1. Remove the emotion from your trading

No trader enjoys being wrong, but since most trading systems are wrong 40-60% of all trades, some traders cannot help but get caught emotionally and let this deter them from taking the next trade. It is not uncommon for traders to be immobilised by the fear of loss and just the thought of executing the next trade is enough to induce a cold sweat, and in some extreme cases, being physically ill. By focusing on the risk reward of the trade and understanding the numbers of your trading system (percentage win and average size of wins compared to losses), traders are able to confidently take the next trade, knowing full well that the outcome is unknown but they have put the odds of a successful trade in their favour. This factor alone is one of the most powerful ways to gain control of your trading edge in the markets and will allow you to fully exploit the advantages you have built into your trading system.

  1. Scale up once you have built the confidence in your trading system

You’ve now identified the risk reward of every trading opportunity and only take those that meet your strict criteria. You’ve also removed yourself emotionally from the thought of being right or wrong on the next trade. You’ve also managed to discipline yourself over the past six months with these principles and you’ve built up your confidence enough to scale up your capital base to the next level from your current base. Congratulations. This is the path of a mature, successful and constantly improving trader.

By applying the concept of risk reward when identifying your next possible trades, you have, over time, put the odds of success in your favour and are now able to allocate a sensible amount of risk to your trades, but at a higher level than before.  For example, when testing over the first six months, you allocated say $200 risk to every trade (1% of $20,000 capital base), just to test the validity of your system and to build confidence in your trading system. Now you have $50,000 in capital to allocate, of which you will still allocate 1% risk – but now it will be $500 per trade and your profitable trades will potentially be a multiple of your higher capital base.

Imagine doing this over a two-year period, building confidence in your system(s) every six months and upon evaluation, considering whether you can scale up to the next level, always staying within a dollar risk amount that allows you to sleep comfortably at night. What level of trader would you be two years from now or perhaps five years from now?

Hopefully those are motivating thoughts and inspire you to utilise the power of risk reward ratios in your trading and more than surpass your trading goals and financial objectives well into your future.

 

ashley_jessen Ashley Jessen is the author of CFDs Made Simple and Director of Communications at Invast Financial Services, one of the largest global markets brokerage firms offering Forex, CFDs, Direct Equities and their proprietary ST24 platform.

 

 

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