Risk reward ratio is a method used by most Profitable Traders.

In this article, you will understand, What it is and How you can use it to increase your trading profits.

What is the risk to reward ratio?

In simple terms- It is how much profit are you making for every Rupee that you risk per trade.

For example-

If you risk 1 Rupee to make 5 Rupee, then the risk-reward ratio is 1:5.

We can also call the Risk: Reward ratio, R multiple.

In which R refers to the risk that we take.

In the above example, the R was 1 and we made 5 R on that trade.

How to calculate the Risk reward ratio

Say you enter a stock at 1000, with stop loss at 980.

And you book profit at 1060.

Now you know what the Risk reward ratio is.

You may have a question: why use this method, what’s the benefit of using this?

Okay, so here you go.

Benefits of using Risk reward ratio

It helps you to focus on Trading, instead of money.

Most of the mistakes you make in Trading are because you are too much focused on the money part of it.

You don’t take your eyes off your M2M, and that’s the reason you make mistakes like –

Exiting the trade without any reason.

Let’s again take the example of My friend Rahul.

He bought Reliance in 2000 with SL in 1950.

Reliance reaches 2020.

Because he was solely focused on the M2M, in fear of losing the profits he exited the trade at 2020.

Now, keep in mind that his Risk was 50 points, whereas he only booked 20 points profit.

This happened because he was so attached to the money part of the trade, he forgot that he made very little compared to the risk he took.

This is the problem you will face if you are only looking at the M2M while you are in a trade.

So, better track how much R you are making in a trade, that way you will think logically.

Now, let’s move on to the second point.

You Do not get fooled by Big profit Screenshots.

You will see many big traders posting big profits.

Nothing wrong with them posting profits, but you only look at the profit and not on how much risk they took to make those profits.

Making 1000 by risking 500 is the same as making 1 Lakh by risking 50k.

The Latter looks more appealing, though it has the same Risk to reward ratio as the prior one.

So, next time you get mesmerized by looking at big profits if you can then ask about the Risk that they took on the trade 🙂

Now, let’s take a look at Real life example of how to calculate Risk reward ratio.

Suppose you bought Reliance at 1620 with SL at 1490.

And you exit the trade at 2180.

Below are the calculations of the trade.

Expectancy

You can also use the Risk: Reward ratio to know the expectancy of your trading system.

What is Expectancy?

In simple terms, it is, What you Expect to make over the next 100 or say 1000 trades.

How to calculate the expectancy using the Risk: Reward ratio or R multiple –

First, you have to have R: R data of at least 100 trades, I will give an example based on 10 trades due to space constraints.

Now, to calculate the expectancy of your trading system, simply add the Total R that you made in Total trades and divide it by the number of trades that you have taken.

In the below example I have taken data of 10 trades, in which I made about 7.3 R.

So total R will be 7.3 And the total trades taken are 10.

It’s better if you have data of at least 100 trades, then you have to divide the Total R with the number 100.

In the above example, My expectancy is 0.73 R.

But, it doesn’t mean that I will make 0.73 R on every trade, it’s just that over a while my average R could be around this number.

Also, one more crucial piece of info that you should have is R: R and win rate should be seen together and not separately-

Most People Run behind systems that have a High Win rate of more than 80-90%.

These systems generally have a profit booking mechanism at, say fixed targets.

That’s why it increases the Accuracy.

But, by doing this they Reduce the R:R.

Take a look at the below chart

A system with 1:1 R: R can break even with a 50% accuracy.

And a system with 1:4 R: R can break even with a mere 20% accuracy.

A system with better R: R can withstand the test of time.

So, it’s better to find a system that has a Higher Risk: Reward ratio and has a low Win rate.

Because if a system has a higher win rate, then R: R will be very low and Room for error will be very less.

We can use R to calculate the minimum win rate we need to break even

Win rate is basically the number of trades on which you made a profit out of total trades.

The formula for minimum win rate is –

Say your system has an expectancy of 0.7.

Then your minimum win rate will be –

From the above formula, you can see that the Win rate is inversely correlated to the R: R

If your R is high that means you are making big by risking less, your Win Rate can be small and still allow you to break even or make a profit.

If your R is Low that means you are making less by risking more, you will need a higher win rate to make money or break even.

If you look at the above graph you can see that you can be profitable even if you have a 20% win rate but your winner should be at least 4 times your losers.

And you can be unprofitable even with a 90% accuracy if your losers are 10X bigger than your Winners.

Most of the big traders, who use the A Trend follow system generally have a 25-30% Win rate but their R: R is much higher (more than 4-5 generally).

So, don’t Just run behind High win rate systems.

Still don’t believe me, then read the below example

I can be Right 99% of the time if I buy Nifty at the open and book just 1 point profit every time, but 1 Loss will Erode all the profit that you will make in 100 trades.

So, that’s it for today from my side.

Thanks for reading 🙂

Trader knight