Traders employ different strategies to get consistent returns from Stock Market. Some trade on fundamentals, some think Technical analysis is the only way to earn money, and there are amateurs who trade just on news and gut feeling. It’s definitely necessary to learn Fundamental or Technical analysis to get an edge in market, but there are few other factors which are must to become a professional trader. Risk and Money management are one of those factors, and they are imperative for long-term success. Its wisely said that “If you learn how to preserve capital, you will definitely learn the ways to multiply it”.
In this post, we would focus on one of the most important money management tools called ‘Risk Reward Ratio”. Mathematically, it’s the ratio of Risk (Money that could be lost), and Reward (Target Profit) for any particular trade. For Ex: If you are willing to risk 1000 Rupees for a target profit of 2000 Rupees, then your risk reward ratio comes to 1:2. Before adopting any trading strategy, it’s necessary to gauge its risk reward ratio for a long term. Most of the modern trading platforms have risk-reward ratio in their back-testing report. Risk Reward ratio of 1:2 is considered good for any trading strategy, and anything less than that can vanish your capital in the long term.
Let’s take an example to understand the significance of risk reward ratio. A trader has developed a Trading strategy with Success Rate of 40% (40 out of 100 trades ends up in profit). When he back-tested his system he found the average Risk Reward ratio for the period of 10 years comes close to 1:3. That means his profit his thrice than his losses in the winning trades. If he loses 1000 Rupees in 60 losing trades, and gains 3000 Rupees in 40 Profitable trades, then his overall profit would be (40*3000-60*1000) 60000 Rupees. It’s a good profit considering that only 40 out of his 100 trades are winners. However, we tend to ignore this fact and always try to improve the Success Rate instead of Risk Reward Ratio. Also newbie traders realize profits quickly and allow losses to grow, which makes risk reward ratio miserable.
Below graph shows how the profitability changes with Risk Reward Ratio. We have taken 100 trades into consideration with a constant stop loss (risk) of 1000 Rupees. Also, the Success Rate has been kept constant as 40%.
It’s evident from the graph that profitability increases with decreasing Risk Reward ratio. The break-even exists somewhere at 1:1.5
Below is another graph which shows the relationship between Success Rate and Risk Reward ratio.
To understand this graph, let’s consider you have a Trading system with superb Success Rate of 80% , that is 80 out of 100 trades are profitable. For such system, the breakeven comes at risk reward ratio of 4:1 (400 lost for every 100 made). Anything better than this would fetch you profits. Conversely, if your Risk Reward ratio is as good as 1:6, you just need to be profitable around 14 out of 100 times to breakeven.
We must always factor in Risk Reward Ratio and Success Ratio while taking any trades, and this would make us better traders in long term. These are very simple to understand but often ignored by majority of traders.