• The Importance of Risk:Reward Ratio

    The reward risk ratio measures the distance from your entry to your stop loss and your take profit order and then compares the two distances.
    Step 1: calculating the RRR
    Let’s say the distance between your entry and stop loss is 50 points and the distance between the entry and your take profit is 100 points .
    Then the reward risk ratio is 2:1 because 100/50 = 2.

    Reward Risk Ratio Formula
    RRR = (Take Profit – Entry ) / (Entry – Stop loss)

    When you know the reward:risk ratio for your trade, you can easily calculate the minimum required winrate (see formula below).

    Why is this important? Because if you take trades that have a small RRR you will lose money over the long term, even if you think you find good trades.

    Example 1: If you enter a trade with a 1:1 reward:risk ratio, your overall winrate has to be greater than 50% to be a profitable trader:
    1 / (1+1) = 0.5 = 50%

    Example 2: If you enter a trade with a 2:1 reward:risk ratio, your overall winrate has to be greater than 33% to be a profitable trader:
    1 / (2+1) = 0.33 = 33%

    Example 3: If you enter a trade with a 3:1 reward:risk ratio, your overall winrate has to be greater than 25% to be a profitable trader:
    1 / (3+1) = 0.25 = 25%

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  • Cheat Sheet for Reward:Risk Ratio and Winrate

    Winrate to Breakeven Minimum Reward:Risk Ratio
    25% 3 : 1
    33% 2 : 1
    40% 1.5 : 1
    50% 1 : 1
    60% 0.7 : 1
    75% 0.3 : 1

    Traders who understand this connection can quickly see that you neither need an extremely high winrate nor a large reward:risk ratio to make money as a trader. As long as your reward:risk ratio and your historical winrate match, your trading will provide a positive expectancy.

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