Are Risk/Reward ratios simply nonsense? | Forex Factory

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Are Risk/Reward ratios simply nonsense?

  • #1
  • First Post: Edited Dec 5, 2012 8:47am Dec 4, 2012 7:33am | Edited Dec 5, 2012 8:47am
Sorry for the provocative looking title, but most of what I've been reading on these forums about risk / reward seems to treat their calculation as simply the difference between opening price and SL/TP ... albeit SL and TP prices derived from (perceived) S/R or trend or phases of the moon.

However, as both the SL and TP are subjective figures drawn by the trader himself, they are irrelevant till one of them is activated. They are simply dots on a screen and have no direct influence on risk (except to the extent that SL may attract stop hunters in which situation having an SL may actually add to the risk, but that's a different story).

In the meanwhile, the real risk is dependent on various technical, fundamental and market sentiment influences.

I'm sure that trading based on those calculations works for some traders, but that has little to do with real risk/potential reward of the trade and more to do with their judgment (or their backtested system) deciding where to place SL and TP in a manner that has worked statistically in the past.

How do YOU calculate potential real risk and potential reward prior to placing a trade?
  • #2
  • Dec 4, 2012 9:10am Dec 4, 2012 9:10am
Quoting WideEyed
Sorry for the provocative looking title, but most of what I've been reading on these forums about risk / reward seems to treat their calculation as simply the difference between opening price and SL/TP ... albeit SL and TP prices derived from (perceived) S/R or trend or phases of the moon.

However, as both the SL and TP are subjective figures drawn by the trader himself, they are irrelevant till one of them is activated. They are simply dots on a screen and have no direct influence on risk (except to the extent that SL may attract stop hunters...
I personally don't use r:r to determine where i should enter/exit. I just let the chart (s/r) do that. Some trades will give me risk to reward of 1:5, and others 3:1. Overall, my r:r is 1:1- but i still need a bit more trade history to back that up...
NocturnalFX is no longer offering commercial services
  • #3
  • Dec 4, 2012 10:14am Dec 4, 2012 10:14am
Quoting VEEFX
My first post outside of the millipede thread on FF so most likely I will delete this within the next 24 hours. R:R is simply overrated by the gurus, mathematicians, literates/intellectuals out here who tend to complicate everything in life. Trading is simple! Entries are not all that important. Knowing 'when' to get out if the trade is not working in your favor instead of waiting till your SL (i.e. defined 'risk') takes you out is my Holy Grail

R:R is supposed to be generated based on your trading statistics as part of your overall...
I suppose acting on calculations done by a bot does remove emotion from the equation which must work to the advantage of some types of personalities.
  • #4
  • Dec 4, 2012 10:46am Dec 4, 2012 10:46am
Of course Risk/Reward is important. Would you risk, say, 5X what you hope to win on a given trade? I'd consider that rather foolish.

Your Risk/Reward is dictated by your strategy, whether it be objective or subjective. This comes from working out the MAE and MFE over a large sample of trades.

Furthermore, the amount of equity you risk per trade should be <= 2%, and this is a generally accepted rule of thumb. This is to limit losses incurred through periods of drawdown.
Most people have the will to win, few have the will to prepare to win
  • #5
  • Dec 4, 2012 11:57am Dec 4, 2012 11:57am
Quoting burnzmeister
Would you risk, say, 5X what you hope to win on a given trade?
Yes, that seems like a good risk ratio if, for example, the probability of winning is >90% and the probability of losing is <10%.

It would be foolish to not take those trades.
  • #6
  • Dec 4, 2012 1:03pm Dec 4, 2012 1:03pm
In my style of trading, i set the stop loss at the point of, "if the market proves me wrong, i am out." The only trades i will take are trades that have a good chance of hitting a 2:1 reward/risk ratio.

Using a reward/risk ratio is just simple way of saying "let profits run, cut losses short." A ratio gives a trader actual values for when to cut losses short and when to take a profit. This helps keep emotions from dictating when and where a trader should exit.
  • #7
  • Dec 4, 2012 3:45pm Dec 4, 2012 3:45pm
Depend on strategy, RR would be useful if trade support resistance zone because price either move within range or breakout. Otherwise, it depends on market probability to hit the TP.
  • #8
  • Dec 4, 2012 6:01pm Dec 4, 2012 6:01pm
Defining risk is not some subjective "dots on a chart" element of trading.

You actually DEFINE the risk when you set a stop loss. If your stop loss is set at 50 pips, then you really are only risking 50 pips because you have the power to pull the plug on the trade. Some will say, "Yeah, but price can gap against you so that you lose more than that 50 pips." But, of course, in these types discussions already build in the fact that price gaping against you is rather rare because you always close your trades out before the weekend if you're a short-term intraday trader or your stop is rather wide if you're an interday trader along with the fact that if price does gap against you come Sunday, there will be as many times that it gaps in your favor as gaps against you. So all those little rabbit trails are considered tabled and it's assumed that your position will be liquidated 99% of the time within a reasonable range from where you put the stop loss.

So risk is defined. What about take profit? Once you put a take profit order in, you have a situation where WILL hit one or the other sooner or later....it's just a matter of how long it will take.

So risk/reward in combination with the win ratio of your system is really just how you calculate expectancy. A system that doesn't have positive expectancy will lose in the long run and since the calculation for expectancy is [(AvgAmtWon x Win%) - (AvgAmtLost x Loss%)] I'd say it's pretty important.

As for building a system based on risk/reward....that's possible too. Remember, regardless of how high big your stop is you can scale your position size up or down so you risk the same Dollar Amount. So a 50 pip stop can be scaled to risk the same $100 as a $10 pip stop. If you set your position size so that you DO risk the same dollar amt per trade (as a percentage relative to the size of your account) and you don't ever move the stop loss or take profit, then you can have a true 2R or 3R system. From there, it's all a matter of the win percentage to determine how successful it is.
  • #9
  • Dec 4, 2012 10:41pm Dec 4, 2012 10:41pm
Quoting FXRenegade
You actually DEFINE the risk when you set a stop loss. If your stop loss is set at 50 pips, then you really are only risking 50 pips because you have the power to pull the plug on the trade.
FWIW, I set my SL based on technical criteria (normally S/R), rather than a fixed number of 'risk pips'. Then my risk is determined, as a % equity, by the pos size that I take. Hence, everything else being equal, the tighter the SL, the greater the number iof lots traded, for the same overall risk:

TradeVolume = [AcctBal x PercentToRisk/100] / [MathAbs(EntryPrice–StoplossPrice) / PipSize x DollarsPerPip]

Thus, for me, TradeVolume is a function of both stoploss size and the PercentToRisk
  • #10
  • Dec 4, 2012 11:45pm Dec 4, 2012 11:45pm
yes it's all bullshit, and what people say about it is also usually bullshit. expectancy, and an actual solid base of trades to back up this statistic, is what counts. r:r on it's own is bullshit. win % on it's own is bullshit. expectancy has the potential for significance.

r:r as a means for describing how a trade played-out, or is expected to play-out, is merely a description. people mistake this as something more meaningful.
Congratulations ScalaFX for coming out of the closet!
  • #11
  • Dec 5, 2012 12:01am Dec 5, 2012 12:01am
Quoting burnzmeister
Of course Risk/Reward is important. Would you risk, say, 5X what you hope to win on a given trade? I'd consider that rather foolish.

Your Risk/Reward is dictated by your strategy, whether it be objective or subjective. This comes from working out the MAE and MFE over a large sample of trades.
Quoting WideEyed
Yes, that seems like a good risk ratio if, for example, the probability of winning is >90% and the probability of losing is <10%.

It would be foolish to not take those trades.
In a game where the odds are fixed it makes sense.
  • #12
  • Dec 5, 2012 12:04am Dec 5, 2012 12:04am
Quoting hanover
FWIW, I set my SL based on technical criteria (normally S/R), rather than a fixed number of 'risk pips'. Then my risk is determined, as a % equity, by the pos size that I take. Hence, everything else being equal, the tighter the SL, the greater the number iof lots traded, for the same overall risk:

TradeVolume = [AcctBal x PercentToRisk/100] / [MathAbs(EntryPrice–StoplossPrice) / PipSize x DollarsPerPip]

Thus, for me, TradeVolume is a function of both stoploss size and the PercentToRisk
Hello hanover.
  • #13
  • Dec 5, 2012 12:04am Dec 5, 2012 12:04am
Quoting nubcake
yes it's all bullshit, and what people say about it is also usually bullshit. expectancy, and an actual solid base of trades to back up this statistic, is what counts. r:r on it's own is bullshit. win % on it's own is bullshit. expectancy has the potential for significance.

r:r as a means for describing how a trade played-out, or is expected to play-out, is merely a description. people mistake this as something more meaningful.
Hello beagle.

WOOF!
  • #14
  • Dec 5, 2012 12:11am Dec 5, 2012 12:11am
Quoting 2+2=4ex
Hello beagle.

WOOF!
le bow wow.
Congratulations ScalaFX for coming out of the closet!
  • #15
  • Dec 5, 2012 12:59am Dec 5, 2012 12:59am
Quoting 2+2=4ex
Hello hanover.
Well hi there!
  • #16
  • Dec 5, 2012 4:49am Dec 5, 2012 4:49am
Quote
yes it's all bullshit
I don't know if that was meant ironically but I wouldn't go so far as to call is bullshit. That it works for mechanistic traders is beyond doubt.

However, in so far as it does not account for velocity of price change, it does not account for volume and it does not account for volatility and other varaibles still at play after you've made the trade, it fails to properly represent the real risk of the position to the expected reward. For example, a sharp change in volatility might warrant early withdrawal from a position and conserve capital by closing the position prior to it reaching SL.

My argument, I guess, is that risk is not represented purely by a product of the position size times distance to SL. While such a simplistic calculation might consistently make money within a custom EA, it is not necessarily an accurate reflection of R/R.

Quoting 2+2=4ex
In a game where the odds are fixed it makes sense.
If the odds of the price rising are the same as the odds of the price falling ... why would you trade?
  • #17
  • Dec 5, 2012 5:21am Dec 5, 2012 5:21am
Quoting WideEyed
I don't know if that was meant ironically but I wouldn't go so far as to call is bullshit. That it works for mechanistic traders is beyond doubt.

However, in so far as it does not account for velocity of price change, it does not account for volume and it does not account for volatility and other varaibles still at play after you've made the trade, it fails to properly represent the real risk of the position to the expected reward. For example, a sharp change in volatility might warrant early withdrawal from a position and conserve capital...
you are saying is that r:r figures only represent a position and not necessarily the actual potential of any one trade. exactly. that's as 'deep' as it generally gets. unless you are talking with someone who actually trades for profit and understands what they are targeting then you can't expect anything more than what you currently get. obviously it can't be any other way.
Congratulations ScalaFX for coming out of the closet!
  • #18
  • Dec 5, 2012 5:28am Dec 5, 2012 5:28am
Quoting WideEyed
Yes, that seems like a good risk ratio if, for example, the probability of winning is >90% and the probability of losing is <10%.

It would be foolish to not take those trades.
If you have a strategy that gives you a probability of winning 90% of your trades, you are still exposed to drawdown!

You say you'd be happy with a 5X risk over 1X reward per trade for such a high win rate. Well say you lose 5 trades in a row where your risk exposure was 2% equity per trade.

If you started with a $10,000 account you would have lost $961:

1st trade: $10,000 * 0.98 = $9,800
2nd trade: $9,800 * 0.98 = $9,604
3rd trade: $9,604 * 0.98 = $9,411
4th trade: $9,411 * 0.98 = $9,223
5th trade: $9,223 * 0.98 = $9,039

$10,000 - $9,039 = $961

How long would it take to get back to your starting equity with a 5:1 Risk/Reward if you didn't lose a single trade from here on?

1st trade: $9,039 * 1.004 = $9,075
2nd trade: $9075 * 1.004 = $9,111
3rd trade: $9,111 * 1.004 = $9,147
4th trade: $9,147 * 1.004 = $9,184
5th trade: $9,184 * 1.004 = $9,221
...
...
...

Okay I'm not going to work all of this out, but I think my point is clear? You only made back $146 over the same number of consecutive winning trades from a drawdown loss of $961.

High Risk/Reward ratios are suicide IMHO
Most people have the will to win, few have the will to prepare to win
  • #19
  • Dec 5, 2012 5:31am Dec 5, 2012 5:31am
I never got entering a fixed TP level...why on earth wouldn't you want to ride the trend as long as you can? Why limit yourself like that?

I currently use relatively tight initial stop losses and set my SL to BE after the first few pips (15-20pips). After that my SL trails as a % of profits behind the current price. No fixed TP whatsoever...
  • #20
  • Dec 5, 2012 5:45am Dec 5, 2012 5:45am
Quoting 4exNinja
I never got entering a fixed TP level...why on earth wouldn't you want to ride the trend as long as you can? Why limit yourself like that?

I currently use relatively tight initial stop losses and set my SL to BE after the first few pips (15-20pips). After that my SL trails as a % of profits behind the current price. No fixed TP whatsoever...
I guess it depends on your style of trading. I try to profit from short-term market inefficiency/volatility, so I don't worry about the trend thereafter, not at the moment anyway. The hardest thing, for me, is to let profits run.
Most people have the will to win, few have the will to prepare to win
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