As we know, all trading involves the risk of loss. So, in every trade, the risk to your capital needs to be worthwhile for you in relation to the potential profit.
Rule 3: calculate your risk vs reward ratio
You can use the risk vs reward ratio to quantify the worth of a trade:
- Your risk vs reward ratio is the amount of risk you're taking on in a trade, compared to the amount of potential reward;
- This is an area where lots of new traders falter. They begin with the belief that they have to 'beat' the market - or 'out-predict' other traders - in order to become profitable;
- There's just one problem with that: it's impossible to predict the future, no matter how much knowledge and experience you have.
So instead of fixating on winning more, professional traders will usually focus heavily on their risk, ensuring that every pound, dollar, etc put on the table as risk capital is worthwhile in terms of the potential return.
To illustrate why, let's look at an example:
Imagine a game of flipping a coin, where you have to guess the result.
On each toss of the coin, you have a 50% chance of your guess being correct. Now, if you lose £1 when you're wrong and make £1 when you're right, you're moving towards breaking even. But as a trader you're not quite there yet, as you need to account for costs like spreads, slippage or commissions.
So even with this arrangement, over the long term, you'll probably lose money.
You could remedy that in two ways:
- First, you could make sure you win on a higher percentage of coin flips. But unfortunately that's impossible - the odds are what they are;
- So the alternative is to win more when you're right than you lose when you're wrong.
Many traders try to take the first option and win a higher percentage of trades. But, although this may seem easier than trying to beat the odds at coin flips, it can still prove very hard to do over the long run.
A much more proactive approach is the second option: look for a bigger reward if you're right than you might lose if you're wrong. This is known as a 'positive' risk vs reward ratio. Returning to our coin flip analogy, now imagine you lose £1 when you're wrong but make £2 when you're right. This would be a 1:2 risk vs reward ratio.
If you're right 50% of the time, the extra profit you make will more than offset what you lose when you're wrong. As we know, all trading involves the risk of loss. So, in every trade, the risk to your capital needs to be worthwhile for you in relation to the potential profit.
And in fact, even if you're only right 40% of the time, you can still be profitable with this 1:2 ratio. If you flipped the coin ten times, you'd lose £6 from your six failures, but make £8 from your four successes.
