In this lesson we’re going to discuss reward to risk. What exactly is reward to risk? Well, quite simply, it’s a ratio that determines how much money you intend to make versus how much money you intend to risk on any one trade. This seems like a simple concept and most people use it in a simplified way, that’s if they use it at all. The majority of people take on way too much risk and don’t take anything into consideration with regards to reward to risk ratios. In this lesson, I will dive deep into how to calculate reward to risk and how it can help improve your trading and hopefully demystify the concept for you.
The first thing we need to know is, every trade has three components in order to calculate your reward to risk. Those components are an entry price, a stop or stop loss price and a target price. Now the entry and the stop are going to be very precise and they’re going to be based on your trading plan, so whatever strategy you’re using or trading tactic you’re using, that will determine what your entry and what your stop loss price is. The price target, however, is going to be a little more confusing. It’s going to be a little fuzzier and a little trickier to determine. The fact remains, though, that you will choose what your price target is. In fact, you might even have more than one price target in place. The key point is that you have to have at least one price target in place before you enter the trade, that’s how you’re going to calculate your reward to risk ratio.
Let’s take a look at a standard formula for calculating a reward to risk. The first thing you would do is determine your total risk by taking the number of shares, your entry price, minus your stop loss price and multiplying that by your number of shares. In this example, let’s say you had 1,000 shares and stop loss of $19.00 with and entry price of $20.00, the difference being $1.00 multiplied by 1,000 shares; you would have a total at risk of $1,000.00. In order to calculate your target, you would multiply that risk by 3 in order to give yourself a 3:1 reward to risk ratio.
This is the conventional wisdom, having a 3:1 reward to risk. You’ll hear that a lot and I recommend it to my clients and my subscribers, in, Trading Master Plan, However, it’s not quite that simple. Using that type of method really over simplifies the calculation. There are some other considerations you need to include in order to calculate this ratio. 3:1 is an excellent rule of thumb and like I said, I recommend that to most of my clients. It’s great for beginners, but if you have a deeper understanding of trading math, you’ll quickly realize that if you lose 4 out of 5 trades, you’re not going to make any money.
If you make $3,000.00 on a trade that you win, and you lose $1,000.00 on a trade that you lose, but you lose 4 times out of 5, you’re still losing money despite the fact you make 3 times the money you win. If you multiply that risk by three, it might result in an area on the chart that’s not likely to be reached, so you’re setting an inflated target by using that method. A good example of this is by looking at a strong area of resistance. It would be pointless to put your target outside of that area because it’s not likely to be reached. You’re just setting yourself up for failure if you’re setting your targets using that method.
Another point to consider is, what if you have a 3:1 reward to risk in your trading plan but you only make 1.5-to-1 or even 1-to-1? Some of the reasons for this might be you sell too early or other psychological issues, the main reason being fear. Over the course of 20 trades if you go back and do the math and you determine that you’re only making 1:1 instead of 3:1, clearly you can see how that’s going to affect your bottom line, long term.
Let’s look at an example of this, visually. You’re expecting to make 3:1 reward versus what you risk. However, if you look back and you calculate the averages and you determine you’re only making $1.00 for every $1.00 at risk, even if you win 50 percent of the time, you’re not going to make any money. In fact, and I have said this and mentioned it in Trading Master Plan that if you can win 3 times as much as you lose, and win only 50 percent of the time, you will make money. But the key is to keep that 3:1 ratio in place and to reach that 3:1 target on a regular basis. If you’re only making 1:1, then you’re just fooling yourself into thinking that you have a good reward to risk ratio. Long term, the results will reflect that.
Next point to consider is even if you do meet your 3:1 target, how many trades are you getting right? It’s very important to determine what your winning percentage is. I touched on that earlier. If you’re winning 50 percent of the time and you do achieve your 3:1 target, then you’re going to make money, in fact, you’re going to be very successful in the markets. With those types of numbers, you could actually win 30 percent of the time and still be an overall winner.
What tends to happen is you end up making your 1:1 target as opposed to 3:1 and if you only win half the time, you win some, you lose some, you really end up getting nowhere, you’re just spinning your wheels in the mud. Once you know what your true reward to risk ratio is and you have a great understanding of what your winning percentage is, you’ve got two key ingredients you’re going to need in order to be successful in trading.
Now that we have a better understanding of what’s involved with calculating reward to risk, we have an idea of what the problem is and most people, if they’re using this at all, are going wrong. In part 2 I will show you how to calculate your reward to risk ratio.