Risk-Reward Ratio: The Math Behind Profitable Trading
Many traders think you need to win to be profitable. That is not true. What really matters is your risk-reward ratio.
What Is a Risk-Reward Ratio?
The risk-reward ratio (R:R) compares the amount you risk to the amount you can win. If you risk €100 to win €200, your R:R is 1:2.
Why It Is Important
Imagine you have a win rate of 40%. That sounds low, but with an R:R of 1:2, you are profitable:
- 40% of 100 trades = 40 winners × €200 = €8,000
- 60% of 100 trades = 60 losers × €100 = €6,000
- Net result: +€2,000 profit
The Magic Threshold
With an R:R of 1:2, you only need 34% of your trades to be winners to make a profit. With an R:R of 1:3, that drops to 26%. This means you can be wrong and still make money.
How to Determine a Good R:R
- Determine your entry: Where are you entering?
- Set your stop loss: Where does your idea become invalid?
- Determine your target: Where will you take profit?
- Calculate the ratio: The distance to your target divided by the distance to your stop
Common Mistakes
The biggest mistake is adjusting your stop loss to force a better R:R. This increases your risk and decreases your chances of profit. Set your stop loss based on the market, not based on what you want to risk.
Conclusion
The risk-reward ratio is the fundamental math behind trading. Understand it, apply it, and you will have a huge edge over most traders.
