manage risk rewards ratio swing trading

Manage Risk Rewards: Guide to Risk Reward Ratio in Trading

manage risk rewards ratio swing trading

Trading can be a risky endeavor filled with ups and downs. One of the keys to becoming a successful trader is effectively managing risk and reward. Understanding and properly utilizing the risk-to-reward ratio is critical for trading success.

What Is the Risk to Reward Ratio?

The risk-to-reward ratio (RRR) measures the potential profit of a trade compared to the potential loss. Specifically, it compares the difference between your entry price and the stop-loss and your entry and take-profit.

For example, if you enter a trade with a stop-loss at $10 and a take-profit at $15, your potential reward is $5 (the difference between your entry at $12 and take profit at $15). Your risk is $2 (the difference between your entry at $12 and stop loss at $10). So, your risk-to-reward ratio would be 2.5 ($5 potential profit / $2 potential loss = 2.5 RRR).

The risk-to-reward ratio shows the amount of potential profit for every 1 unit risked. A higher risk-to-reward ratio is generally better since it means you can risk less and profit more on winning trades.

Why Is Risk to Reward Ratio Important in Trading?

Risk to reward ratio is crucial for trading success because, as a trader:

  • You will not win 100% of your trades
  • You need to manage your risk of losing trades.
  • You need to maximize profits on winning trades.

Even the best traders only win 50-60% of the time. By having a proper risk-to-reward ratio, you can still be profitable overall despite losing trades.

A 2:1 ratio is commonly recommended – it means your potential profit is twice as much as your potential loss. This ratio gives you a buffer to handle some losing trades but still come out ahead.

Without proper risk-to-reward management, you may win a lot of trades, but the losses could still cause you to lose money overall.

Calculating Risk-to-Reward Ratio

Here is the basic calculation for risk to reward ratio:

Risk to Reward Ratio = (Take Profit – Entry) / (Entry – Stop Loss)

For example:

  • Entry Price: $50
  • Stop Loss: $48
  • Take Profit: $54

Risk = Entry – Stop Loss = $50 – $48 = $2

Reward = Take Profit – Entry = $54 – $50 = $4

Therefore, Risk to Reward Ratio = $4 / $2 = 2

So this trade has a 2:1 risk-to-reward ratio – $4 potential profit vs $2 potential loss.

The higher the ratio, the better the reward relative to the risk. Most traders recommend at least 1:1, preferably 2:1 or higher.

Common Ratios

Here are some common risk-to-reward ratio targets:

  • 1:1 – Break even ratio. The reward equals risk – not ideal for most traders.
  • 2:1 – Recommended baseline ratio for most trades.
  • 3:1 – Very good ratio for higher probability trading setups.
  • 5:1 – Excellent ratio suited for high-accuracy pattern trades.

Determine your personal optimal ratio based on your trading strategy, win rate, and money management rules.

Determining Stop Loss and Take Profit Levels

Setting appropriate stop losses and taking profits to achieve your desired risk-to-reward ratio involves analyzing the following:

  • Where key support and resistance levels are
  • Market volatility and typical price movements
  • Your personal risk tolerance

Generally, tighter stops are used for shorter-term trading, while wider stops are used in swing or position trading.

Take profits are based on upside price targets, typically at the next resistance area, moving average, or chart pattern projection.

Get in the habit of planning your trades by marking:

  • Logical stop loss level below entry based on supports
  • Minimum take profit level above entry based on targets

This helps ensure you have an edge before entering each trade.

Ideal Risk to Reward Ratios for Different Trading Styles

The optimal risk-to-reward ratio depends greatly on your timeframe and trading style.

Intraday and Day Trading Ratios

For very short-term trading, tighter stops are usually placed due to the fast pace of price action.

Intraday traders typically use a 1:1 minimum ratio up to 2:1 or 3:1 for high-probability setups.

Day traders can use wider stop losses to target 2:1 or 3:1 ratios. Very precise day trades could see 5:1 or more being possible.

Aggressive traders may use lower ratios but must win a high percentage just to break even.

Swing Trading Ratios

Swing traders aim to capture larger price moves over days or weeks. This allows placing stops further from entry for normal price fluctuations.

Minimum swing trade ratios tend to be 2:1, but 3:1 or higher is recommended, especially early in your trading career. This gives you ample margin to remain profitable despite losing trades.

Very strong chart patterns and precision entries occasionally allow swing trader ratios in the 5:1 to 10:1 range if the trend move is expected to be especially large.

Long-Term Position Trading Ratios

Position traders aim to capture long-term trend moves lasting weeks, months, or longer. This enables wide stops of 50% or more while profiting greatly from extended moves.

Minimum position trade risk-to-reward ratios should be at least 2:1, with ideal trades generating 5:1 or higher. Ongoing bull markets can see phenomenal wins from extended runner profits, sometimes giving ratios of 10:1 or 20:1.

Choose target profit areas conservatively during uncertain markets but can be ambitious in strongly trending sectors.

Tips for Improving Risk-to-Reward Ratios

Here are some key tips for getting better risk-to-reward ratios in your trading:

  • Wait for strong chart pattern breakouts – Use confirmed technical signals on your trade timeframe. This provides precisely defined entry, stop loss, and profit target placement.
  • Take only high-probability trades – Solid risk-to-reward management starts with having an edge before entering a trade.
  • Use wider stops for swing trades – Give some breathing room for normal retracements to avoid getting stopped out prematurely.
  • Use multiple take-profit areas – Scale-out some profits at the minimum target and let the remainder run for outsized gains.

Improving your risk-to-reward ratio discipline takes experience but is crucial for trading longevity and profitability.

Risk-to-Reward Ratio Examples

Let’s see some examples of calculating risk: reward for sample forex, futures, options, and stock trades:

Forex Risk Reward Ratio

EURUSD at 1.1200 Stop loss at 1.1150 Initial take profit at 1.1300

Risk = Entry – Stop Loss = 1.1200 – 1.1150 = 0.0050 or 50 pips Reward = Take Profit – Entry = 1.1300 – 1.1200 = 0.0100 or 100 pips
RR Ratio = Reward / Risk = 100 / 50 = 2

This currency pair trade has a 2:1 profit potential relative to the risk taken.

Futures Risk Reward Ratio

Crude oil futures at $65.50 Stop loss at $64.00 Take profit at $68.00

Risk = Entry – Stop Loss = $65.50 – $64.00 = $1.50 Reward = Take Profit – Entry = $68.00 – $65.50 = $2.50 RR Ratio = Reward / Risk = $2.50 / $1.50 = 1.67

This commodity trade has roughly 1.7:1 risk-reward.

Options Risk Reward Ratio

Long call option at $3.00 Sell option on losing trend at $1.50 stop loss Take profit by selling at $5.00

Risk = Cost – Stop loss = $3.00 – $1.50 = $1.50 Reward = Take Profit – Cost = $5.00 – $3.00 = $2.00 RR Ratio = Reward / Risk = $2.00 / $1.50 = 1.33

This options trade risk-reward is roughly 1.3:1 which is generally low.

Stock Risk Reward Ratio

Stock entry at $25.00 Hard stop loss at $23.00 Take profit at next resistance level near $28.00

Risk = Entry – Stop Loss = $25.00 – $23.00 = $2.00 Reward = Take Profit – Entry = $28.00 – $25.00 = $3.00
RR Ratio = Reward / Risk = $3.00 / $2.00 = 1.5

This stock trade has $3.00 of profit potential for every $2.00 risked which is an okay minimum 1.5:1 ratio.

Final Words

A positive risk-to-reward ratio is key for trading success and profitability over the long run. Strive for at least 1:1 or higher RRR on all trades, and use effective trade planning strategies to maximize your potential gains while controlling downside risk.

Tracking and reviewing your risk-reward results and ratios allows you to determine if any adjustments or refinements are needed to your system rules or trade execution. Fine-tune until you are consistently netting out more rewards than the risk taken!

FAQs

What is a good risk-to-reward ratio?

A minimum 2:1 ratio is recommended but most traders strive for at least 3:1 or higher, especially early in your trading career. This provides enough profit buffer to overcome losing trades.

What risk-to-reward ratio do professional traders use?

Many pros use a 3:1 ratio as their baseline for shorter-term trades. Higher probability setups can achieve 5:1, while longer-term trend trades could see 10:1 or better.

Is a 1:1 risk-reward ratio good?

A 1:1 ratio is generally not ideal long-term since it offers no cushion for losing trades. Aggressive short-term traders may use 1:1, but most look for better ratios to account for losses.

What happens if the reward ratio is too high?

An extremely high ratio like 10:1 may seem fantastic but could indicate your take profit is too ambitious and may not get triggered before a reversal. Find a balance between optimism and realism.

Can you be profitable with a 1:2 risk to reward?

A 1:2 risk-reward ratio means your potential losses are greater than your projected profits. This is very difficult to profit in the long term without an exceptionally high win rate above 70-80%.

Is it better to risk more for a higher reward?

Higher reward potential trades typically require risking more capital. The key is ensuring your profit target sufficiently compensates you for the higher risk – stick to minimum 2:1 ratios even on more aggressive trades.

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