You will come across many gurus and traders claiming the importance of having a low risk-to-reward ratio in your trading to achieve any kind of success. Their argument might be convincing when you think about it, but is it really viable in real world trading? I personally believe that this myth will only restrict your strategy ideas and it is not always a necessary case especially in building Expert Advisors (Trading Robots).
Risk-To-Reward Ratio
Simply put, risk-reward is a ratio of the amount you are willing to risk and lose, to the amount you want to gain. If you are willing to lose $1 to gain $3, you will have a 3:1 risk-reward ratio. As you can see in the following illustration, a pending order is placed with a 60 pip stop-loss and 180 pip take-profit, which means this trade has a 3:1 risk-reward ratio.
Low Risk-to- Reward Trade
Following that, if you win 1 trade for every 3 that you lose, you will break even in your trading, and by having a trading system with more than 25 percent winning rate, you will have a winning trading strategy. That's where the myth starts, and where some try to make us believe that aiming for a low winning rate means that it is easier to accomplish. This is neither true nor more probable, otherwise, placing random orders with a low risk-reward ratio gives us a winning system in our hands, and that is not the case. Nonetheless, do keep in mind that this doesn't mean that there are no winning trading strategies with low risk-reward trading.
Proving Market Randomness and the Effect of Risk-Reward
I have come across a case study online with a trader experimenting and trying to prove that placing random trades with a low risk reward ratio, give a positive outcome. The problem with his experiment was that the data sample was too small. Fact is that if you have a big enough sample size, you will be amazed by how random the market is and ineffective his trading was.
I have created a simple EA that will open sell orders one after another, and have it run for more than 10 years of historical market data for different currency pairs (The minimum allowed spreads in the strategy tester of MT4 was used to have the least interference on the results). In my first test, I used a 1:1 risk-reward (150pip s/l & t/p).
(You can download this EA for experimental purposes by clicking here.)
The results simply show that when using 1:1 risk-reward at random, you will have a 50/50 chance of winning your trades. Now lets see what happens if we try using a low risk-reward of 3:1 (50 s/l, 150 t/p) and a high risk-reward of 1:3 (150 s/l, 50 t/p).
These results say everything. All of the pairs' percentage of total trades won are so close to each other, and given how the results are always breaking even, by factoring in spreads, you will lose in the long run.
When Does Applying a High Risk-Reward Makes Sense?
Bollinger Band Breakout EA Backtest with High Risk-to-Reward
Bollinger Band Breakout EA Backtest with Low Risk-to-Reward
I know that this might be the opposite of what traders try to have you believe, but I would like to demonstrate that high risk-reward sometimes is the better option. I backtested an EA of a Bollinger Band breakout strategy that is part of my portfolio, on the EURUSD m15 with high vs low risk-reward of the stop-loss to take profit in each trade, the results show that due to nature of price flow of this pair at this time frame, a higher risk-reward provided more gain and a smoother system. The rules of this strategy is what gives it an edge, not the low risk-reward.
When creating a system don't put a higher emphasis on risk-reward per trade. Broaden your ideas when developing your rules and look at all of the systems criteria like losses in a row, equity curve, profit factor, drawdowns, etc. Don't fear developing strategy rules that others disagree with because in the end all you seek is a rule that gains profit.
Let me know what Risk-to-Reward ratio works best for you.
Orca-FX.com
Risk-To-Reward Ratio
Simply put, risk-reward is a ratio of the amount you are willing to risk and lose, to the amount you want to gain. If you are willing to lose $1 to gain $3, you will have a 3:1 risk-reward ratio. As you can see in the following illustration, a pending order is placed with a 60 pip stop-loss and 180 pip take-profit, which means this trade has a 3:1 risk-reward ratio.
Low Risk-to- Reward Trade
Following that, if you win 1 trade for every 3 that you lose, you will break even in your trading, and by having a trading system with more than 25 percent winning rate, you will have a winning trading strategy. That's where the myth starts, and where some try to make us believe that aiming for a low winning rate means that it is easier to accomplish. This is neither true nor more probable, otherwise, placing random orders with a low risk-reward ratio gives us a winning system in our hands, and that is not the case. Nonetheless, do keep in mind that this doesn't mean that there are no winning trading strategies with low risk-reward trading.
Proving Market Randomness and the Effect of Risk-Reward
I have come across a case study online with a trader experimenting and trying to prove that placing random trades with a low risk reward ratio, give a positive outcome. The problem with his experiment was that the data sample was too small. Fact is that if you have a big enough sample size, you will be amazed by how random the market is and ineffective his trading was.
I have created a simple EA that will open sell orders one after another, and have it run for more than 10 years of historical market data for different currency pairs (The minimum allowed spreads in the strategy tester of MT4 was used to have the least interference on the results). In my first test, I used a 1:1 risk-reward (150pip s/l & t/p).
(You can download this EA for experimental purposes by clicking here.)
The results simply show that when using 1:1 risk-reward at random, you will have a 50/50 chance of winning your trades. Now lets see what happens if we try using a low risk-reward of 3:1 (50 s/l, 150 t/p) and a high risk-reward of 1:3 (150 s/l, 50 t/p).
These results say everything. All of the pairs' percentage of total trades won are so close to each other, and given how the results are always breaking even, by factoring in spreads, you will lose in the long run.
When Does Applying a High Risk-Reward Makes Sense?
Bollinger Band Breakout EA Backtest with High Risk-to-Reward
Bollinger Band Breakout EA Backtest with Low Risk-to-Reward
I know that this might be the opposite of what traders try to have you believe, but I would like to demonstrate that high risk-reward sometimes is the better option. I backtested an EA of a Bollinger Band breakout strategy that is part of my portfolio, on the EURUSD m15 with high vs low risk-reward of the stop-loss to take profit in each trade, the results show that due to nature of price flow of this pair at this time frame, a higher risk-reward provided more gain and a smoother system. The rules of this strategy is what gives it an edge, not the low risk-reward.
When creating a system don't put a higher emphasis on risk-reward per trade. Broaden your ideas when developing your rules and look at all of the systems criteria like losses in a row, equity curve, profit factor, drawdowns, etc. Don't fear developing strategy rules that others disagree with because in the end all you seek is a rule that gains profit.
Let me know what Risk-to-Reward ratio works best for you.
Orca-FX.com