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In this lesson, you’ll learn how to use the risk reward ratio to improve your risk management and achieve greater success in trading. Understanding this fundamental concept will help you measure potential gains against possible losses and determine how much return you can expect for each unit of risk you assume.
The risk reward ratio measures the potential gain against the possible loss for each trade. Every trade must be executed with a well-defined plan that includes setting stop loss and take profit targets. For example, if you buy 100 shares of a stock at $30 per share with a stop loss at $25, your maximum potential loss would be $500. If your target is $40, your potential profit would be $1,000, resulting in a risk reward ratio of 1 to 2.
You can improve your risk reward ratio by adjusting your stop loss levels. If you reduce the risk to $3.30 while maintaining the profit target at $10, the ratio becomes 1 to 3. However, a tighter stop loss might lead to your trade being closed earlier, so you need to balance these factors carefully.
The risk reward ratio should be compared with your strategy’s success rate. A risk reward ratio of 1 to 2 allows you to remain profitable even if only 33% of your trades are successful, compared to a 50% success rate required for a 1 to 1 ratio. With a higher risk reward ratio, you can achieve breakeven or profitability with a lower percentage of successful trades.
Analyzing your trading strategy statistically and determining the value of your risk reward ratio is essential for long-term success. This concept helps you understand how often you need successful trades to achieve breakeven or profitability, making it a key tool in effective risk management.
Video Chapters
00:00 – Introduction to risk reward ratio
00:36 – Practical example with stock shares
01:20 – Adjusting stop loss to improve ratio
02:02 – Success rate and breakeven analysis
Key Takeaways
The risk reward ratio measures potential gain against possible loss for each trade
A 1 to 2 risk reward ratio allows profitability with only 33% successful trades
Adjusting stop loss levels can improve your ratio but may increase premature trade closures
Higher risk reward ratios enable breakeven with lower percentages of successful trades
Video Transcription
[00:00:00.05] - Speaker 1 In this lesson, we will explore the risk reward ratio, a fundamental concept in improving risk management and achieving success in trading. The risk reward ratio measures the potential gain against the possible loss for each trade and represents our potential return for each unit of risk assumed. Every trade must be executed with a well defined plan that includes setting stop loss and take profit targets. It is important to analyze your trading strategy statistically and determine the value of your risk reward ratio. Let's describe this with a practical example.
[00:00:36.26] - Speaker 1 Suppose you buy 100 shares of a stock at $30 per share and you set a stop loss at $25. In this case, your maximum potential loss would be $500 or $5 times 100 shares. Your target is for the stock to reach $40 within the next six months, providing a potential profit of $1,000 or $10 times 100 shares. In this scenario, you are risking $5 per share to potentially gain $10, resulting in a risk reward ratio of 1 to 2. By adjusting the stop loss, you can improve the risk reward ratio, but this might increase the likelihood of triggering the stop loss prematurely.
[00:01:20.11] - Speaker 1 For instance, if if you reduce the risk to $3.30 while maintaining the profit target at $10, the risk reward ratio becomes 1 to 3. However, a tighter stop loss might lead to the trade being closed earlier. The risk reward ratio should be compared with the success rate of your strategy. A risk reward ratio of one to two, for instance, allows you to remain profitable Even if only 33% of your trades are successful, compared to a 50% success rate required for a one to one risk reward ratio. Additionally, the concept of the number of positive trades needed to breakeven is important.
[00:02:02.10] - Speaker 1 The risk reward ratio determines how often you need successful trades to achieve breakeven or profitability. With a higher risk reward ratio, you can achieve breakeven or profitability with a lower percentage of successful trades, as shown in this table. In conclusion, the risk reward ratio is a key tool in risk management and understanding its implications can significantly contribute to your trading success.
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