Hi guys, hi from Andrea Unger! Today, I’d like to spend a few words on the risk-reward ratio in trading. For instance, is it true that a 3:1 risk-reward ratio is the best one, or is this just a legend?
According to many traders, the ideal risk-reward ratio is 1:3. Actually, some people believe this is the Holy Grail of trading.
However, I do not agree with them. The risk-reward ratio depends on the type of strategy you use. So, there are strategies in which you might have a reward that is even smaller than the risk.
I have plenty of these strategies. Am I crazy? No, I am not, because the point is these strategies have a winning percentage that is much higher than 50% (the coin toss percentage).
Suppose we have a strategy with a stop loss of $1,000 and a take profit of $500, and we have 10 winners and one loser. If we win $500 ten times and lose $1000 once, this means we gain $4,000.
So, as you can see, the kind of strategy you use plays a major role.
In the case with classical trend following strategies, or long-term trends, you normally don’t use a take profit, as it would cut your runs, and that would be a nonsense. Therefore, the reward is much wider than the risk. However, in these strategies you are stopped out very often; you can have false breakouts and trends that don’t start.
So, you enter many times and get many small stops. However, when you finally win, you gain a lot. This means you have a large risk-reward.
Instead, if you use countertrend strategies, rebound strategies, swing trading strategies and the like, sometimes you use take-profits that are smaller than the stop loss you put in place. The reason is that you want to catch a fast rebound and leave breathe to the trade if it goes against you. Actually, you wait for that moment when the move changes direction.
To conclude, the 1:3 ratio is nothing but a legend. This is probably told by people who never clicked on a mouse to catch the trade. Believe me, risk-reward ratio depends on the kind of approach you adopt.
Ciao from Andrea Unger!