Risk and Reward ratio-an alternate view

The concept of a risk/reward ratio is simply for any given trade, you're targeting a certain amount of gain, while setting a stop-loss limit if the trade goes the against your direction. As a trader you want your reward to be at least a little better than your risk, a good rule of thumb is to seek a return of three times as much as the amount risked and making the reward/risk ratio 3 to 1 or anywhere between 2 to 1 and 4 to 1.

So as long as you're rewards are bigger than your risks, over time you will make money ? Unfortunately, it is not necessarily true , it is the the likelihood of a number of successful trade with the highest percent of gain that give the most reward.

Let's stick with the assumption that our optimal reward/risk ratio is 3 to 1 and assume you have a developed a trading system that produces one winning trade for every four trades. So, your win/loss ratio is 1 in 4 (25%), while your reward/risk ratio on a per trade basis is 3 to 1. Do you think you will make money with that system? Nope - for every trade that gains 30%, you have three more trades that lose 10%. The rewards were three times as big as the risk, but it didn't create any real profit! The best you could hope for is to break even.

Let examine another example. Say you've found a stock you think will move 20% higher, and you're willing to risk 10% to enter that trade. You're target is 20% above your entry price, and your stop loss is 10% under your entry price. With a reward/risk ratio of 2 to 1, this trade doesn't necessarily seem all that great. But, what if the trading system had a success rate of three winners for every four trades? You'd have a 75% chance of making 20%, while only a 25% chance of losing 10%. With that particular trade, your real reward-to-risk ratio would be about 6 to 1.

Bottom Line – The point here is not the setting of targets and stops based on a predetermined risk/reward ratio . Big targets and tight stops are pointless if the system is a net loser. Rather, focus on the actual risks and rewards of a total methodology. This will also force you to determine just how successful your trading system or stock picking really is.