Tag: risk-reward ratio

  • How to improve risk management in trading?

    How to improve risk management in trading?

    How to improve risk management in trading?
    Improving risk management in trading could be a life-changing factor.

    By Guy Avtalyon

    I’ll start straight to the point on how to improve risk management in trading. Risk management in trading very often stands very low on the priority list for many traders. The main concern is the entry signal or other indicators. I have to tell you this isn’t the right way. Nothing is wrong with waiting for the proper indicator, but if you don’t have decent knowledge about risk management in trading, you will not have profitable trades. The point is to know how to manage your risk, size your position for each trade, and set your orders accurately if you want to make a profit in trading.

    And you might think it is unnecessary, and it isn’t so important. If that is your case, feel free to not continue with reading this post. But I have to warn you that if you never improve risk management in trading, you’re at risk of becoming a steady loser. 

    And why should you be that if there are some tips to avoid the most common problems?

    Tips to improve risk management in trading

    If you adopt some of these tips or approaches, you’ll stop losing your hard-earned money.

    First, you must realize how you let the trade get out of your hands. Yes, it’s kind of looking back but never think about this as wasting your time. If you make a scrutinizing evaluation of your past trades that ended in losses, you’ll find the reasons behind them, and you’ll find the pattern. The main benefit of this introspection is to avoid similar behavior in the future. Knowing how and why you made mistakes, you’ll be prepared and will never repeat the same trading mistake in the future.

    Setting orders and the risk/reward ratio

    When you identify an entry signal, do you know where to set your stop-loss and take profit orders? You have to know that even before you enter the trade. How to do that? Let’s assume you know where to set the stop loss and take profit orders after determining the appropriate price levels. The next step should be to measure the risk/reward ratio.

    If you find out the risk is bigger than the reward, just skip the trade. The worst thing you can do is stretch the take profit order or squeeze your stop loss to reach a higher risk/reward ratio.

    Keep in mind; trading is mostly unpredictable, so the reward isn’t assured. The only thing you can control is the risk involved in your trades. You shouldn’t neglect that and act unreasonably. I’m a hundred percent certain that most of you determine the risk/reward ratio randomly and adjust your stops and profit orders to reach that ratio. Guys, it’s an entirely wrong way.

    Compare win rate and risk/reward ratio together

    Many traders insist that figuring out the win rate is pointless. But they miss out on a crucial point. Watching the win rate alone has no value, but if you observe win rate and risk/reward ratio together, you’ll be closer to winning trades. Having winning trades is every trader’s dream.

    I want to be clear with this, you shouldn’t necessitate an excessively high win rate. For instance, a trading strategy with a win rate of 40 percent requires a risk/reward ratio below 0.6 to be profitable.

    A win rate of 40 percent is average for the most profitable traders. Why should you want an insanely high win rate? That’s wrong and could lead you to significant losses.

    Balance win rate and risk/reward ratio

    You must find a balance between the win rate and the risk/reward ratio. For example, the high win rate could mean that the risk/reward ratio also is high. 

    Suppose you found a stock that is trading at $20, down from a recent high of $25. And you bought 50 shares because you had $1,000 for that purpose.

    If the stock price went up to $25, you can make $5 for each of your 50 shares, and in total it is $250. You paid $1,000 so you have to divide 250 by 1,000 and the result is 0.25.

    That means that your risk/reward is 0.25:1. It is a very low risk/reward ratio.

    Assume that you have made 15 trades, of which 6 were winners and 9 were losers. So, the win/loss ratio is 6/9, or 2:3. In percentages, the win/loss rate is 6/9 = 0.66. This means you are losing just over 66 percent of the time. Using your total number of trades which is 15, your win-rate would be 6/15 = 0,4×100 = 40%.

    You can be profitable with a 40 percent win rate if risk/reward is below 0.6. As can be seen from the formula for calculating the needed win rate for profitability based on the risk/reward ratio, 1/(1+ risk/reward ratio).

    The risk/reward decreases when the win rate decreases. In other words, if you have more losses, your winners must be bigger to be profitable.

    Size your position

    I’ve met many traders that size their positions randomly picking some levels of 2 percent, 4 percent, and never change that. It’s totally insane. You have to estimate the chances to win because trading is all about possibilities. It’s normal to change position sizing for every trade if it is necessary, and mostly it is. Why should you hold the same position size when you see virtually no chances of winning? 

    In trading, every strategy has a different win rate. So, the risk/reward ratio for each of your trades will vary. This is especially important if you trade using many strategies or setups.

    The point is to reduce the trades’ position size with low win rates and increase it for the trades with higher win rates.

    If you want to improve risk management in trading, you should never overlook the risk/reward ratio and money management. Otherwise, you’ll blow your account. If you take too much risk to make a quick profit, you’ll likely end up in losses. 

    You’ll go bankrupt because of a lack of knowledge about risk management. Now onwards, you have to rigorously adhere to position sizing and risk management if you want to be a profitable trader.

    Pay attention and improve risk management in trading

    You might love your trading style or some strategy, particularly, but you should consider improving it to achieve more profitable trades. After some time, everyone should jump to the next level. I know you could be impressed by indicators, waiting for the right signals to show you the right time to enter the trade. It’s so exciting and sexy, right?

    Well, it’s also risky if you never improve your risk management. It isn’t so exciting as watching the charts, candles, following the news, and waiting for the indicators, but it is essential for your future trades and your profits. Blinking indicators and trading strategies will benefit you for some time, but the real difference comes with improved risk management.

    Don’t be worried. A small number of traders really pay attention to this matter unless they have a series of losing trades. Then and only then. they will start thinking about how to improve risk management in trading. But you have a chance to shortcut this path. Why suffer losses if you can trade with more attention to the risk management from the beginning instead. 

    It doesn’t take too much. 

    Did I miss something? Share your opinion with me, leave a comment, ask me what else you would like to know. I’m here for you, guys.

  • The risk-reward Ratio

    The risk-reward Ratio

    3 min read

     

    The risk-reward ratio is a formula used to measure the expected gains of a given investment against the risk of loss.

    It is typically shown as a figure for the assessed risk separated by a colon from the figure for the prospective reward. The adequate ratio can vary, but trade experts recommend a ratio between 2:1 and 3:1 to determine a worthy investment.  

    Typically, the ratio quantifies the relationship between the potential money lost, should the investment or action fail, versus the money realized if all goes as planned.

    In other words, the risk-reward ratio measures how much your potential reward is, for every coin you risk.

    For example:

    If you have a risk-reward ratio of 1:2, it means you’re risking $1 to potentially make $2.

    But, if you have a risk-reward ratio of 1:4, it means you’re risking $1 to potentially make $4.
    Investors use the risk-reward ratio to define the viability or worthiness of a given investment. You can limit risk by issuing stop-loss orders,  sometimes. That will trigger automatic sales of stock or other securities when they hit a particular price. If you don’t implement such a mechanism in place, the risk is likely endless.

    How to use the risk-reward ratio like a pro

    Let’s be clear: the win rate in trading it totally trivial on its own. Some traders put way too much importance on the win rate. At the same time, they don’t understand that a win rate will not tell you anything about the quality of a practice or a trader.

    The truth is that trader can lose money with a 70% or even with a 90% win rate if few losers are so big that they wipe out trader’s winners. But, the trader can have a successful system even with a win rate of 40% or only 30% if such a trader lets winners run and cut losses short.

    It all comes down to the reward-risk ratio.

    The reward to risk ratio (RRR, or reward risk ratio) is probably the most important metric in trading. A trader who understands the RRR can improve his chances of becoming profitable.

    But, however, there are some myths about risk-reward.

    Myth 1

    “You need a minimum of 1:2 risk reward ratio.”

    That is nonsense.

    Why?

    Because the risk-reward ratio is insignificant on its own.

    We will give you an example:

    Let’s say you have a risk-reward ratio of 1:2. This means, for every trade you win, you make $2.

    But, your winning rate is 30%.

    To have a clear picture, out of 10 trades, you have 7 losing trades and 3 winners.

    Let’s do the math…
    Total Loss = $1 * 7 = -$7
    Total Gain = $2 * 3 = $6
    Net loss = -$1

    You see, you are not the winner.

    And you understand the risk-reward ratio by itself is an insignificant metric.

    There is nothing like good or bad risk-reward ratios. It just comes down to how you use it. You can even trade profitably with a risk-reward ratio of 1:1 or less.

    So, you must combine your risk-reward ratio with your winning rate to know whether you’ll make money in the long run. That is known as your expectancy.

    Myth 2

    The risk-reward ratio is useless

    Some traders like to say the reward-risk ratio is useless. It cannot be further from the truth.

    When you use the RRR in combination with other trading metrics, such as win rate, for example, it instantly matures as one of the most important trading tools.

    Without knowing the risk-reward ratio of a single trade, it is literally impossible to trade profitably.

    The risk-reward ratio isn’t enough

    Do you want to know the secret code?

    Here it is.
    E= [1+ (W/L)] x P – 1

    Now let’s put this all together and let’s take a look at some performance statistics and how the RRR fits in.

    Below, we see a performance simulation based off a strategy with a win rate of 50% and a risk of 2.5% per trade. The RRR was first set to 2:1 on average per trade.

    The Risk - Reward Ratio 3

    You can see that out of those 20 simulated outcomes (the different graphs), all of them were positive after 500 trades.

    Remember, with a win rate of 50%, you just need a RRR greater than 1:1 to trade profitably. With a 2:1 RRR you can potentially trader very profitable with a win rate of 50%.

    Now let’s take a look when the only thing we change is the RRR. Everything else is the same.

    Assume that each trade has a RRR of 1:1.

    Out of the 20 simulated outcomes, only a few will generate a positive outcome and many show a negative outcome.

    To conclude, with a win rate of 50%, trading a RRR of 1:1 is very volatile and variance will be huge. You have to remember, with a win rate of 50%, you need a RRR greater than 1:1.

    Now let’s take a look when the only thing we change is the RRR. Everything else is the same.

    Assume that each trade has a RRR of 1:1.

    Out of the 20 simulated outcomes, only a few will generate a positive outcome and many show a negative outcome.

    The Risk - Reward Ratio 4

    To conclude, with a win rate of 50%, trading a RRR of 1:1 is very volatile and variance will be huge. You have to remember, with a win rate of 50%, you need a RRR greater than 1:1.

    The bottom line

    Portfolio with more unknown factors may have a higher probability of failure but at the same time offer a significantly higher return if they are successful. The ideal is the low risk-reward ratio – the little risk of failure and a high potential for reward. 

    risk disclosure