What you need to know about Risk-Reward Ratio

I am surprised to see people keep arguing the basic Risk:Reward concept and the usefulness of it. I think it should not be a very complicated concept to deal with.

The goal of trade is to make profit. It is not necessary to have a minimum RRR, but the combination of RRR and winrate has to be profitable, and of course the more profitable, the better.

Note that RRR is Risk:Reward, the bigger is the value, the risker is a trade.

In a simplified model, breakeven trades are ignored and each trade risk the same amount and target for the same amount of reward.

Thus,
Average Profit/Loss per trade = WinRate * Reward - (100% - WinRate) * Risk

For a profitable method:

WinRate * Reward - (100% - WinRate) * Risk > 0

WinRate - (100% - WinRate) * RRR > 0

Therefore,
...................RRR
WinRate > ----------
................(1 + RRR)

For example, for in a trading method, a trader risk 5 unit for 1 unit reward.

The WinRate has to be achieved to be profitable is 5/(1+5) = 83.3%

If such a WinRate is achieved, it is a profitable method.

Nevertheless, to answer how profitable a method is, we need to make use of the concept of profit factor.
.

My favorite measure of the profitability of a method is Profit Factor, it is simply the ratio of Gross Profit/ Gross Loss. i.e.

......................Gross Profit
Profit Factor = --------------
......................Gross Loss

In terms of RRR and WinRate, Profit Factor can be calculated in this way.

Profit Factor = Gross Profit / Gross Loss
..................= WinRate * Reward / ((100% - WinRate) * Risk)
..................= WinRate / ((100% - WinRate) * RRR)

Mathematically, the objective of a trader is to optimize the function of the Profit Factor by finding the best combination of WinRate and RRR as in the formula.

(Note that another important element need to be considered when evaluate a trading method is the frequency of the setup. The more setup given by a profitable method the better. Nevertheless, this element is not discussed here.)
.....................

Although multi-stage profit-taking strategy is commonly used in many trading methods, the concept can be the same.

The RRR and WinRate can be determined based on the actual trade result. For example, there are 14 trades in a sample below, with 4 breakeven trades ignored in the calculation.

-20........0........200
-40........0........140
-50........0........300
-20........0........240
-80
-30
----------------------
-240(6)...0(4)...880(4)

In this example, the average risk is -240/6 = -40, and the average reward is 880/4 = 220.

The RRR is thus 40/220 = 2:11

And the WinRate is 4/(4+6) = 40%.

The Profit Factor would be 880/240 = 3.67

Hope this can clarify some misunderstanding about RRR.
........

A lot of trading methods are notoriously difficult to pin down as to how much profit or loss they'd make over time. Dozens or more times, you'd have to write down exactly how you decided each trade exactly according to the trading method, and not deviate from the trading method.
Many people who trade change their method slightly every day or week, and psychology severely weights against any test of a trading method's effectiveness being reliable. Plus, a method the person trading uses without consciously declaring it, such as the "I just know that part" when observing the unseen motions of the tick and the related new price, could be involved.

I've always admired people who could make an r:r, and am completely for and want to do it.
Any advice on how to get past the above difficulties, or correction of any misconceptions the above states?

OK this really simple.. RRR
ie.
If your stop loss is 25 pips make sure your target is 75 or better 100 pips
BUT The secret is to find a good Stop loss - if you can not find one do not take trade
Also it helps trading with the trend!

its that simple.

Good info... thanks.

good read. thanks for sharing, newbies should look into RR and basic stuff more than just how to make big bucks

Very Good read specially for newbies. Thanks for sharing

What i don't understand about R:R is how do people know what the reward will be? Yes you can guess that price will probably move to the next S/R zone but that also has a 50/50 chance of happening.

A lot of people say aim for a minimum of 1:2 but how on earth do you guarantee that the profit is double the loss if you don't have control of how price moves?

If I were planning to use a Risk:Reward ratio of 1:1 and assume I have a 50% WinRate.
This is just sufficient to break even.

But, suppose I moved the stop loss to break even on trades that went in my favor early on.

I may get stopped out on minor pull backs which otherwise would have ended up reaching tp.

Do you think the positive effects of eliminating risk on ~50% of trades offsets negative possible effects of altering Risk:Reward ratios?