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How To Use the Risk Reward Ratio Like A Professional.
http://www.financial-spread-betting.com/course/risk-versus-rewards-stops.html PLEASE LIKE AND SHARE THIS VIDEO SO WE CAN DO MORE You have probably heard of the risk-reward ratio, and maybe even heard advice that says you should have 3:1 or 5:1 reward to risk on any trade you take. On the face of it, that sounds sensible, but if you’re going to win at trading you need to take into account probabilities. OK.
For any trade, if there is no other indication, it’s probably 50/50 whether the price will go up or down. There’s a neutral expectancy. And if you took a trade with a 1:1 risk-reward ratio, you’d finish up even over time (less any fees) and there really wouldn’t be any point.
In the same situation, if you use a risk/reward ratio of 3:1 or 5:1, the chances are that success in the first case would only be 33% of the time and in the second case 20% of the time, again taking a neutral expectancy for the price to go up or down. So again trading would make no sense.
As a trader, you want to stack the odds in your favour. You do this by selecting the trade that you want to make. For instance, you might be looking at a pullback in a rising trend and identifying a low point or support level before the trend continues. If you’ve done your homework and made sure this is the situation, you could reasonably say that the chance that the price will go up is much more than the chance the price will go down. Perhaps there’s a 75% chance of the price rising compared with a 25% chance of the price falling further.
Now, if you place a trade that the price will go up with a risk/reward ratio of 1:1, you will over time make a profit. The price is going to go up three times out of four and only go down once out of four trades, on average, so this is a sensible trade to make.
It’s also possible to look at this from the other point of view. Say you had a risk-reward ratio of 10:1, and estimate that your chance of success in this trade is only 30%, i.e. 70% of the time the trade will fail and you will be stopped out on your stop loss. Would you want to make this trade?
If you’re following along, then you should say of course. I don’t care that my trade fails seven times out of 10 if it succeeds three times out of 10 and each time I win 10 times the amount I lost on each losing trade. I’ve lost seven and won 30 “units” for a healthy profit.
So you see it is not such a simple question as what your risk-reward ratio is to decide whether you want to make a trade. You must take into account the probability of success, that is the probability of either outcome. Successful trading requires that you form an assessment of the market and put the odds in your favour every time you take a trade. You win some and you lose some, but you want probability on your side.
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