RISK REWARD RATIO EXPLAINED - Does 2:1 Still Work?

In this video you are going to discover why using 2:1 or 3:1 reward to risk ratio for your trades isn’t a very good idea. In fact, I am going to show you a real study in detail demonstrating what happens when you take trades with a reward to risk ratio between 0.5:1 and 5:1

When looking at a potential trade to make it is quite common to look at the potential profit available which we call reward. Clearly there is risk involved in every trade too. One common way to measure risk is by placing a stop loss.

For example a stop loss of 100 pips or points is our risk. We can also set a limit order to take profit at a predefined amount of pips or points too. In this case we will use a target or reward of 200 pips giving us a reward of twice our initial risk. Expressed as a 2:1 reward to risk ratio trade.

But how do we know that 2:1 is the best reward for any given trade?

In the video I am going to test different reward to risk ratios and back it up with real trading results.

If you didn’t already know, I am a mechanical or rule based trader. Which means I look for certain conditions to give me entry and exit signals for each trade.

The strategy I am running the test on is quite a simple but effective one which uses an inside daily bar as a setup and then a break of the high or low to buy or sellshort. I have ran the test on AUD/USD Forex pair over 10 years ranging from 1/1/2010 until 1/1/2020.

The risk is calculated by the range of the inside daily bar, or by subtracting the low from the high. For example 120 pips. So the stop loss is 120 pips away from our entry price. So a profit target of 240 pips would give us a Reward to Risk ration of 2:1

The normal exit I use for this strategy is a timed based exit at the end of the trading session. So regardless of whether the trade is in profit or a loss, I will close the position at the end of the session.

The actual strategy isn’t the focus of this video though. The focus is to test various reward to risk ratios (profit targets) to see how the performance changes.

I have programmed the strategy and included an additional profit target using Multicharts platform which I use to test and trade strategies.

Watch the video to see the results of the test.

A few important points to note about choosing Reward to Risk ratios:

* Every strategy and market has a different optimal Reward to Risk ratio – what works for one, won’t always work for another.

* Sometimes using a fixed Reward multiple as an exit will lose money as you can see in this article.
When using a fixed Reward multiple you are forcing your requirements onto the market. Sometimes the market will only offer what it has to offer.

*Often time based or signal based exits are far more profitable than using a fixed Reward multiple as a profit target.

*There are other factors such as winning percentage which determine the profitability of a trading strategy.

In addition don’t believe everything you read! You will often read about only taking 3:1 or 2:1 Reward to Risk ratio trades. But quite often these statements are either very old and/or not backed up by proof.

I recommend you test everything before trading live with real money. You can run back tests like the one I have displayed in this article. But back tests aren’t fail proof as they only show you what has worked in the past. But wouldn’t you rather trade something that has proven to work well in the past than something that has continuously lost money in the past? I know I would!

Click through to the blogpost link to get the rules of the original profitable strategy used in this test.

DISCLAIMER:

I am not a financial advisor and I am not offering you financial advice. I am not regulated in any way. The purpose of the content I provide is for educational purposes only.

Any information you receive is based on my own knowledge and experience in the financial markets and how you act on the information provided is your own responsibility.

I cannot be held responsible for any losses you may incur as a result of ideas taken from my content provided.

[thumperbumper]

My typical trades are 1.5 risk to 1 reward. On the entry. Ya kind of backwards, but I have timed exits and the longer held, my stops come tighter also. In the end the real risk to reward on real trades is about 1:1.3.

[Corvette]

So is this basically confirming that no one can try to predict future prices? That setting 2:1 etc ratios is just a way for humans to feel a bit more secure in a trade but in reality we have no idea of the future price action. So lying to ourselves regarding a future price point is senseless and that we should be more fluid in our sell points?

[Hamstersssssssssssss]

AUD/USD only moves around 60-70 pips a day . If you run a test with a 100 TP you won't hit it often cause price reverses after hitting daily range. Run the same test in something like GBP/AUD and you'll get different results .

[kumakama]

For my strategy it turned out 1.2:1 to 1.3:1 gives most consistent long term yield, since higher RR means lower win rate and thus at some point wouldnt offset the difference in lost trades.

[onzi]

This is a pointless video as it will only apply to that pair, time and strategy

[gifropan]

Hi Gerald

I enjoyed watching your video. I have watched a lot of videos and often instinctively rejected the enforcement of a risk/reward ratio. I have seen many profits disappear because I was waiting for the target that was never reached. As you say, the market gives you what the market gives you. You cannot dictate terms. The most useful and sensible video I have ever watched on trading.

[hbof]

Good point, I trust the data more that what people say

[hamidijafri]

He mentioned a good point. Don't force the risk reward ratio. Depend on situation and volitility then we place the target (within a range if you're scalping). Move the stoplosses as the price move your way towards your target zone.

[soleray]

good job man, it really helps, maybe using time-based exits is better in most circumstances

[dedjene]

Awesome video and great data! Just had a question, a few months later you came out with a video that showed that the 1.8R produces the highest ROI. I wanted to know why it performed so poorly in this video? Thank you!

[nylixneylix]

Something doesn't make sence in that software. All these risk/reward rations are profitable according to their winrate.
For example, 1:1 with 64% percent winrate. Out of 1000 trades for example this would be 640 trades winning and 360 loosing, giving 280 profit.
Then there's 1:2 with almost 49% winrate and probably thebest one, 1:5 with 41% winrate.
How can this loose money if you win more then you loose?

[TheTransparentTrader]

Don't believe everything you read! TEST everything because as you see in this video 2:1 or 3:1 reward to risk isn't always best!

[maxmaxi]

This man is so right
If there was a reward ratio just think about it there will be no money in the trading system as why it's at 6 trillion dollars in CFDs as why as people money is in it
If it did work everyone would be rich lol
I been trading for 10 years
I am only breaking even that's all

[meaversand]

I have no clue what kind of strategy u use, but I dont think that any FIX strategy is working for the long time anyway
you have to learn to read the market and make up your mind, have a good SL which might make a big difference and dont forget, a profit is a profit, you never lose a dime if you take profit
Trading is not only a skill its also mentally, if you cant handle losing trades, you better stop trading, because no RR or therefor a strategy will work for you anyway..OMHO

[WJGSix]

I haven't watched the video yet, but I tend to start taking profits at around 1.5 - 1.7 ish reward and hold for 2.5 on the second half of my position. I feel it's an emotional thing, cause I feel I trade scared all the time and focus more of my loss than my gains. At least I try to.

[ShareefusMaximus]

So I know this is old, but it seems to me that if the price is moving away from you when you enter, say on a mean reversion strategy where you buy at an oversold level, the R to R could be 1 to 1 or even less. While the big reward numbers should be for breakouts where the price is already moving your way and any reversal is an immediate sign that the trade may not be valid. Would it matter what market and strategy you tested these ratios on? I think this maxim assumes that you trade volatile trending markets.

[gan]

sir, my trading plan is using fixed 1.2 : 1 reward to risk ratio in all my trades, but in some of them i only take 0.6 : 1, half of my target,
what i want to ask is that a good strategy for a long-term trading?

[pncedzc]

What is the strategy u used? Why did you chose to enter? is my question. The exits are clear. But your reason to enter is not.

[ma-mvmv]

I am confused. doesn't 2:1 reward to risk depend on what strategy you use? Because for such a reward you need to enter very well and need to be picky as to Where you enter. You don't mention what strategy you used for the video above and or how good your entries are. can you please clarify.

[agbkorf]

"here you have the proof" I choked laughing. You didn't take in account the variabillity in relation to the chosen percentages of the stop and profit limits. The chosen percentages of the stop and profit limits should be within the range of variabillity to even hit a win. This should be somewhere around 1 to 2 times the standard deviation. Go 3 if you want to do high risk trading. So, in other words: You need to do a matrix analysis where you vary two different variables. 1st variable is the R/W versus the 2nd variable being the chosen percentages of the stop and profit limits. The chosen percentages of the stop and profit limits should be within 1 to 3 range in the expected period of hitting win.