Is a high risk reward ratio overrated?

I would like to challenge the dogma of having a high risk reward ratio. Is this really necessary to be a profitable trader? I've been trading live for almost a year and a half now, and I've only just begun to be consistently profitable when I stopped trying to "let my winners ride" so that I could acheive a risk reward ratio of say 3:1 for example. All I really managed to do was give most of my profits back to the market. I don't have a problem cutting my losses short, as I've seen that the vast majority of my profitable trades are in profit right away. I've never felt the need to hold on to a losing trade hoping the market will come back, so getting out of a losing has never been an issue. I don't believe a trader is giving in to fear if he or she chooses to take a profit almost right away. In fact it seems that the further price moves away from entry, the less likely you will be to hit your target. This is proven by the fact that systems with smaller T/P will have a higher win % than systems with higher T/P. I don't think it's necessary to have a ratio where you risk 100 pips to gain 10, but I see no reason why something closer to 1:1 would not work on a regular basis.

Risk Reward ratio in general is overrated
But cutting your losses and letting your profits run isn´t.

How far does one let your profits run? If a trader is really letting their profits run, is there a reason to close a trade other than you have a signal to go in the opposite direction? To do so would be picking tops and bottoms.

Sis,

I don't think there's any problem with you challenging that theory at all.

In the end, though you'll find that your RR combined with your win ratio will have determined your profit.

RR by itself is not enough...you need to have the statistical edge in your win ratio in order for RR to mean anything.

Whether or not you should center your trades AROUND RR is somewhat ridiculous to me since the only way RR means anything would be if you knew your winning percentage.

Where RR IS important is determining the probability of being profitable based on your expectation of your system performance given the variable RR.

For example, it's not enough to know that the market goes up or down 50% of the time...that information alone will not make you profitable. Where it becomes relevant is when you finally add in RR and say that the market reaches TP before SL z% of the time...and while blindly adhering to that theory that the history will continue is obviously ridiculous, what that information DOES give you is a plan of action...and that plan is definitely a better start than saying, I'll place a trade and hope it goes up more than 50% of the time.

I don't really trade with a set RR. Like you, I"m more flexible when it comes to deciding those types of things, but I do use RR as a way to calculate my "safe zone" to know whether or not my trading has become too aggressive or too conservative based on how far outside of the expected RR I get.

Note that it's equally important to be consistently and constantly validating your expectancy in conjunction with your RR.

I pay absolutely no attention to risk/reward ratio. I only pay attention to what the current price action is telling me. I think it's a style of trading (maybe even an element of a system) rather then a principle to be followed by all.

With my methods trying to adhere to a risk/reward would end up in losses.

There really is no hard or fast rule.. obviously.. It depends on what your trading decisions are based on. If you are trading via indictors then its hard to say what your exact stops would be.. it maybe when indicators reverse or stochs come out of oversold or overbought, but we cant know exact price that would happen. If you are trading patterns, I think its way easier.. Here is an example, say you are trading a breakout of a flag or pennant pattern.. then your stop should be on the opposite side of the breakout.. You can select very precise stops for that situation. As for entry, you can select your entry on the breakout till the next major resistance. Now if that happens to be 10 pips away and your other end of the flag or pennant is 25 pips away where your stops lie, you may reconsider that trade unless your entry happened maybe 5 pips away from your stop..
So you see, its much easier for a trader to determine risk reward in those situations than putting an arbitrary number of 1:1, or 1:3 risk to reward ratios.. It really comes down to your analysis, what are you trading, what time frame. If you constantly find yourself trading to get 10 pips risking 30 or 40 pips, and if you are still profitable, then you might want to consider, why is it that your entry is so bad where you are risking so much, maybe if you can't at that point get your entry to be at a better price, you should consider scaling in your entry where everytime the price goes against you by 10 or so pips you enter the market while still keeping the same overall lot that you wanted to enter the market with.. Its like cost averaging into your position. Then you may still get to that 10 pips target price, but since you averaged your entry position, you will notice that your risk to reward ratios automatically gets much better.
I know this may not apply to you but since its a discussion and it seems that people often wonder about this, I just wanted to throw out a few points to show how someone may want to look at their particular situation instead of just looking for a 1:2 or 1:3 risk to reward ratios.

Ron

The issue is really expectancy. Given a large enough sample of trades, what's your average return going to be?

If your trades are successful 50% of the time and your risk reward ratio is 3:1, and you're risking 10 pips to make 30 on a typical trade, then your expectancy is 10 pips per trade. (For every 30 you make you lose 10, which leaves you 20 pips between the two trades for an average of 10 per trade). That's great! You're profitable.

If your trades are successful 75% of the time and your risk reward ratio is 1:1, and you're risking 10 pips to make 10 on a typical trade, then your expectancy is 5 pips per trade. (You make 30 pips for every 10 you lose. But the 20 net pips in your favor is divided over 4 trades). That's still fine. You're still profitable.

And if you're capable of the second scenerio but not the first, then the second is obviously a better option. But just don't overlook the effect a lower risk reward ratio has on expectancy.

What I do is slowly scale out of the position. If my stop loss is 15 pips below my entry, then when the trade has moved 15 pips in my favor I close 1/3 of the position. This way, if things completely turn around and I get stopped out, I've only lost 1/3 of my original risk (I lose 2/3 on the remaining position, offset by the 1/3 profit). Often, if things turn around, though, I'll liquidate at my original entry point if the reasons I entered the trade in the first place are no longer valid. Then I have a small profit--not enough to have justified the risk, but better than a loss.

Or, if the reasons I originally took the trade are still valid, I'll load the position back up when it's retraced back near my entry point. This way, my total risk is still less than it was originally (because if I get stopped out, the loss is offset by the profit I took earlier), and I'm position for an even greater profit.

Plip

A similar discussion has been going on here recently.

Focusing solely on Reward/Risk ratios and not what the market is doing is only going to increase the number of times you lose. You should let the market give you an exit signal, and not some arbitrary reward to risk ratio. The market doesn't care how much you risk or profit, it only cares about price.


As Kenny Rogers says: "Don't count your money when you're sittin' at the table. There's a time enough for countin' when the dealin's done."

Risk to reward ratio matters as much as profit to loss ratio does. A good money management strategy can help save a poor trading strategy or poor execution.

There is a couple of things people should keep in mind though when looking at their limits and stops. It's best to try and use natural market resistances/supports to establish the limits and stops used. Don't let an idea about having to have a certain R/R ratio influence where you put them. The market doesn't care where you think they should be for your MM strategy. If you feel you need that certain R/R ratio then don't enter a trade that the natural resistances don't fall within your ratio strategy.

Also it's good to keep in mind that every trade won't likely have the same exact R/R ratio baked into the price action and the more flexible you are with that aspect the more opportunity you have given yourself for successful trades. It's a good idea to have a minimum ratio that a trade needs to meet before you'll enter. So if you have a resistance that is serving as a stop 25 or so pips below the position, the limit should be what you have determined as your minimum ratio acceptable and that natural market resistances reflects and supports this.

Also I would suggest using a trailing stop or a manually adjusted stop to capture profits as the price moves in your favor. So if you have a 50 pip stop and a 150 pip target I would move the stop to secure profits keeping in mind the volatility of the pair so as not to get it hit by normal volatility levels of that pair. Typically as soon as the price extends over the 1:1 ratio, in the previous example that would be 50 pips, I look to try and lock that in as soon as it allows it with pair volatility kept in mind. So at that point even if my target gets missed and reverses on me I have secured not only a break even but my (theoretical)stop loss for my next trade.

I know a trader who is also a manager of over 100 mil of customer accounts that trades in a 'set it and forget it' fashion. His system creates 150 pip targets as a minimum with upwards of 1000 pip targets and he will not trade unless there is at least a 4:1 ratio. He only brings his stop up to a 1:1 ratio after the trade moves to 2:1 and then does nothing else. That's it. This guy is one of the most successful traders I have ever known personally. I can't even trade his strategy as I'm not disciplined enough to yet.

So MM strategy is very important, probably the most important part of any trader's plan to trade. It's just that it should be flexible enough to allow the trader to succeed according to the way the market has set up it's natural resistances/supports. You can't have a one size fits all template that you slap on every trade. There needs to be some adjustment to the market according to each trade and the market climate at the moment of trade. Have a formula that fits your trading style but also recognize that it should have some flexibility in it or you will struggle to succeed over the long haul.

I would say it's mostly for the entry part. For the exit you should never let it determine your exit. But that being said if you go for a 3:1 you're likely to miss out on some very decent trades. I think one of the reasons why it caught on it was simply a way to keep people from making spur of the moment trades for a quick profit, which are often the riskier trades.

Personally I don't really pay it much attention, my exit will be when I feel it turns against me. Most times now I don't even have a clear target point unless I'm going for small 30-50 pip moves. And while most of my stops are around 10 pips, It's not much of a factor if it only moves 10 pips before I get out. I tend to focus more on my entries to reduce my stop loss, which I feel is far more important (limiting my losses). Exits are fairly easy, when it breaks a support or resistance (normally a trend line) if I'm trending the move or hits a S/R level when I'm going for short 30 pip moves. but I seldom try to predict where it will end anymore, I just let it do all the work now.

In conclusion I do think it's helpful for keeping you from making to risky of trades. It's not one of the most important factors to having a good trading strategy. While it's fun trying to predict where, when and how much the market will move, it's often a futile attempt. Your time is likely better focused on more productive endeavors to help increase your overall trading.

That's an excellent point. If you risked 15 pips when you got into a trade and you hoped to get 45 out of it, that doesn't mean that you don't close out at whatever point the market tells you to. You have to be flexible--not subjective, but flexible.

I would guess that for the majority of my trades, I don't end up exiting at either my original stop loss or my original target. That's because over the course of the trade, the market gives you more information, and you can adjust your expectations.

If it's obvious that the trade isn't doing what you hoped it would, there's no reason to wait until it hits your original stop loss. And if it goes half way to your original target and then peters out and gives every indication that it's going to reverse, then take what profit you have and be done with it. On the other hand, there are times when I let a portion of the trade run into profits well beyond the original target.

My TP is trend end and my SL trend end.

Un,
I agree totally. I found that when I focused too much on RRR that I lost more. Now my focus about 90% of the time in trading is on finding the best entries and exits for my trades based on my system.

RRR is useful later to analyze how you did and to see how you can improve.

All that said, a high RRR is not a smart idea either. The tortoise wins the race.