What is Risk-Reward Ratio
The risk reward ratio should actually be called the reward risk ratio, since the first number – the RRR is generally denoted like odds at a race track – is usually the reward number, and the second is the risk. So, if you were looking at a risk reward ratio of 2:1, that means the reward is twice that of what is being risked.
The risk reward ratio is different than another popular statistic, that of risk-adjusted return, or alpha. Alpha calculates, in effect, the quality of the investment, whereas the risk reward ratio is simply a description of the risk you are taking to get a certain reward. For instance, if a risk return ratio is 4:1, that doesn't say anything about the probability of that large return actually materializing. It is, as its name implies, the ratio of risk and reward.
Furthermore, the risk reward ratio refers only to the risk and the reward of the investment itself – it does not refer to the potentially negative effects of that investment on your capital. Hence, changing how much you leverage a particular purchase does not actually change the risk reward ratio, even though the effective risk to your account may be fundamentally altered.
Without stop losses it is very difficult to calculate risk. Unless your currency pairs will automatically be sold at a certain point, the notion of how much money you are truly risking becomes an extremely subjective notion. The same can be said about less liquid currency pairs where there is a chance you will not find a buyer when the currency pairs starts to slide rapidly.
One thing to remember about the risk reward ratio is that it rarely if ever is set in stone. There are many ways to manipulate your risk reward ratio. Changing your stop loss orders is just one example. You can also reduce the amount you are looking to earn – that is, your exit point. By lowering your exit point, you reduce both how much you may earn, and the total risk you are exposed to.
Example
The risk reward ratio reinforces the importance of always placing stop losses. If you risk $20,000 to gain $40,000, then that is a 2:1 risk reward ratio. But if you forget to but that stop in there, and the currency ends up falling three times what you expected to gain, before you notice, then you are looking at a risk reward ratio of 2:3, which is a completely unacceptable ratio.
What is an acceptable risk reward ratio depends on your goals, the length of your exposure, and the probability of the reward being fulfilled. If it seems very probable that a reward will materialize in the time frame you have alloted, then you could very well be content with a ratio of 1:1. However, if there is only a 1:2 chance of the trade going your way, then you need a very large risk reward ratio to make it a logical investment.
The general rule of thumb is this: your risk reward ratio, times the probability of your reward materializing must be greater than the opportunity cost of other investments you could be making with that money.
Of course, probability is a whole heck of a lot harder to calculate than the risk reward ratio, but that's another subject for another time.
The risk reward ratio should actually be called the reward risk ratio, since the first number – the RRR is generally denoted like odds at a race track – is usually the reward number, and the second is the risk. So, if you were looking at a risk reward ratio of 2:1, that means the reward is twice that of what is being risked.
The risk reward ratio is different than another popular statistic, that of risk-adjusted return, or alpha. Alpha calculates, in effect, the quality of the investment, whereas the risk reward ratio is simply a description of the risk you are taking to get a certain reward. For instance, if a risk return ratio is 4:1, that doesn't say anything about the probability of that large return actually materializing. It is, as its name implies, the ratio of risk and reward.
Furthermore, the risk reward ratio refers only to the risk and the reward of the investment itself – it does not refer to the potentially negative effects of that investment on your capital. Hence, changing how much you leverage a particular purchase does not actually change the risk reward ratio, even though the effective risk to your account may be fundamentally altered.
Without stop losses it is very difficult to calculate risk. Unless your currency pairs will automatically be sold at a certain point, the notion of how much money you are truly risking becomes an extremely subjective notion. The same can be said about less liquid currency pairs where there is a chance you will not find a buyer when the currency pairs starts to slide rapidly.
One thing to remember about the risk reward ratio is that it rarely if ever is set in stone. There are many ways to manipulate your risk reward ratio. Changing your stop loss orders is just one example. You can also reduce the amount you are looking to earn – that is, your exit point. By lowering your exit point, you reduce both how much you may earn, and the total risk you are exposed to.
Example
The risk reward ratio reinforces the importance of always placing stop losses. If you risk $20,000 to gain $40,000, then that is a 2:1 risk reward ratio. But if you forget to but that stop in there, and the currency ends up falling three times what you expected to gain, before you notice, then you are looking at a risk reward ratio of 2:3, which is a completely unacceptable ratio.
What is an acceptable risk reward ratio depends on your goals, the length of your exposure, and the probability of the reward being fulfilled. If it seems very probable that a reward will materialize in the time frame you have alloted, then you could very well be content with a ratio of 1:1. However, if there is only a 1:2 chance of the trade going your way, then you need a very large risk reward ratio to make it a logical investment.
The general rule of thumb is this: your risk reward ratio, times the probability of your reward materializing must be greater than the opportunity cost of other investments you could be making with that money.
Of course, probability is a whole heck of a lot harder to calculate than the risk reward ratio, but that's another subject for another time.
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