“profitable Risk-reward Ratios: Strategies For Success In The Australian Forex Market”

“profitable Risk-reward Ratios: Strategies For Success In The Australian Forex Market” – If you ask me how many pips I made last month, I will tell you that I don’t know.

Check out my R-lot last month: a 6.1R gain. This R number often causes confused looks. What does R stand for?

“profitable Risk-reward Ratios: Strategies For Success In The Australian Forex Market”

To understand this, we need to look back at our performance and its relationship to risk.

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Saying you made a profit of 50pp only tells me part of the story. The key information that is missing here is how much risk you are willing to take to earn this profit. After all, a profit of 50 pips is a good result if you have a stop loss of 25 pips, but if your stop loss is 200 pips, you are risking a lot for a relatively small reward.

In the first example, your profit is twice your risk. Your reward:risk ratio is 2:1. In the second example, however, your profit is only 1/4 of your risk. This results in a much less attractive reward:risk ratio of 0.25:1.

While there are many different ways to trade, we can agree that a 2:1 reward:risk ratio offers much better prospects if you have a strategy with the same win rate.

But how can we measure these risk-adjusted returns if not in pip? That’s where R and R-multiples come in.

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R stands for Initial Risk. The first risk is how much you are willing to lose on a trade. The initial risk can be expressed as a percentage of the account amount (for example, 1%) or as a percentage of the dollar amount you lose when the price reaches your stop loss (for example, $50).

Let’s take an example here. You go long 0.1 lot on EURUSD with a stop loss of 100 pips. Unfortunately, the price moves against you, hits your stop loss and you lose $100. That $100 is your initial risk or 1R. Now you can say you lost 1R.

Now, all profits and losses can be expressed as multiples of the original risk. That multiple is called an R-multiple. You want your losses to be 1R or less and your profits to be as large as possible.

Let’s go back to our EURUSD example and let’s say you see that the price is going against you and you cut your loss halfway to your stop loss:

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Instead of your stop loss being the full $100, you now only have $50 to lose. We can express this as the initial risk (or R) multiplier.

The R-multiple on this trade is a loss of -0.5R. Let’s look at another scenario in this business where we can make huge profits:

We made a profit of $128. Again, we can calculate our R-multiple as the initial risk (or R) multiple:

Since we can express the result of each trade as an R-multiple value, it is easy to calculate the R-multiple sum of many trades. Assume you had 5 transactions last week.

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Adding the above values, we can say that our total R-multiple for the week was +2.94R. This one number shows how our performance was for that week, not just the profit or loss, but how much risk we have for it. It is a more accurate way of evaluating performance than pips or ticks.

By using R and R-multiples we can measure our performance accurately. But how does this relate to the actual dollar value of our businesses? After all, consider the following two trades.

Assuming both are winners, we can say that both trades represent a 2R profit. However, one trade made $100 while the other trade made $400 in profit! How does this relate to R-multiples? The answer is position size.

Position size refers to the number of units we use when trading. In forex trading, this means our lot size. In futures trading, the number of contracts we place and in stocks, the number of shares we trade in one place.

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By adjusting our position size, we can change how much we are willing to risk (or profit) when trading. Usually a trader chooses a position size strategy and when an overview of position size falls outside the scope of this article, I will highlight one strategy.

In this strategy, we adjust the position size so that our initial risk (or 1R) always represents a certain percentage of the account size. Imagine your account size is $10,000 and you risk 1% per trade, then the initial risk of each trade you make is $10,000/100 = $100.

A fixed fractional position size ensures that as your account size grows, the risk you take on each trade will grow accordingly. When you increase your account to $15,000, then 1% of each trade is at risk of the first $150.

Assuming a 1% risk for a business means that 1R will be equal to 1%. Imagine you earn 4.5R in one month. Using a fixed fractional placement rate, this increases the account balance to about 4.5%. If your risk in a trade is 2 percent, a gain of 4.5R will result in a 9 percent increase in account balance.

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Instead of just using pip, using the concepts of R and R-multiples provide a powerful way to consider your performance at risk. Measured against the amount of risk involved in achieving your performance, the result is a more accurate way to determine how well your business is doing.

Still have questions about how it works? Let me know in the comments or get in touch!

FX and futures trader, using price action, market profile and order flow to trade markets. I am also interested in psychology and algorithmic trading. Follow me on Twitter: @GhostwireTrader

FX and futures trader, using price action, market profile and order flow to trade markets. I am also interested in psychology and algorithm trading. Let me get it out of the way: winrate in itself is completely irrelevant in business. Many traders put too much emphasis on winrate and don’t understand that winrate tells you nothing about the system or the quality of the trader. A few of your losers are so big that you can lose money with 80% or 90% winnings if you wipe out your winners. On the other hand, if you are good at letting winners run and shorting losses, you can have a profitable system with a 50%, 40% or even 30% win rate. It all comes down to your reward risk ratio. The risk-reward ratio (RRR or reward-risk ratio) is perhaps the most important metric in trading, and understanding RRR can improve a trader’s chances of being profitable. Reward Risk Ratio Myths To understand what most people get wrong, let’s first look at some common misconceptions about RRR before getting into the details of RRR and how we use it. Myth 1: Reward-Risk Ratios Are Worthless Traders often say that the reward-risk ratio is worthless, and they read over and over again that it couldn’t be further from the truth. When used in combination with other marketing metrics (such as winrate), RRR can quickly become one of the most powerful marketing tools. Without knowing the reward ratio of a single trade, it is literally impossible to trade profitably and you will soon learn why. Myth 2: “Good” and “Bad” Reward-Risk Ratios How often have you heard someone talk about a general, randomly selected “low” reward-risk ratio? Even popular business books often state that a minimum RRR of 2:1 or higher is required – mostly without knowing any other business criteria. There is no such thing as a good or bad reward risk ratio. It just comes down to how you use it. As we will see later, you can trade profitably with a reward ratio of 1:1 or less. Further reading: Why I choose a low trading system Myth 3: A bad trade is not better with a high reward risk ratio Many traders think that by using wide profit or close stop loss they can easily increase their reward risk ratio and, therefore, improve their trading performance. Unfortunately, it’s not that simple. Using a wider profit order means that the price will not easily reach a taken profit order and you will likely see a drop in your winnings. On the other hand, placing your stop will increase premature stop runs and you will be kicked out of your trades too early. Amateur traders often confirm “bad” trades where they are not trading

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