Risk-Reward Ratio Calculations for Traders
What is a risk/reward ratio? A simple definition goes something like this:
A ratio used by traders to compare the expected returns of a trade to the amount of risk undertaken in order to capture these returns.
Calculating a risk/reward ratio for prospective commodity trades should be an integral part of your overall trading plan. Many novice traders make the mistake of only calculating the potential rewards of a trade.
This is great if the trade goes your way. If it doesn’t, as is very likely, you stand to lose heartily – because you haven't set an exit point based upon an analysis of risk.
Risk/reward analysis essentially falls under the trade selection process of a trading plan because if a potential trading opportunity doesn’t meet the ratio it should be discarded as a possible trade. However, it can also placed under the money management part of an overall trading plan since it deals with defining risk levels. I typically consider it part of my trade selection process because it deals with weeding out good and bad trades rather than dictating how much capital to allocate and commit for trading. In either case, it is a necessary step in your trading plan.
Calculating a risk/reward ratio
A simple and oft-used ratio is 3:1. This means the expectation of profit should be three times the amount risked or the trade should not be made. One might reasonably ask how a risk/reward ratio can be accurately made if the amount of reward (potential price movement) is unknown. This is a valid point since nobody can possibly know if or how far a price will move in the near future.
However, there is a quantity that is clearly defined and can be known in advance of a trade – your risk. This is why it is best to start with the risk portion of the ratio. Using your money management guidelines, which dictate how much capital can be risked, you can now build the risk/reward ratio upon that figure.
Now, this doesn’t alleviate the difficulty of forming a fairly accurate estimate of a reward that is three times your risk level. But, it does put the onus on a known figure instead of an unknown figure, which is a much more reliable solution.
However, an estimate of potential reward must still be made. This can be done with a wide assortment of price forecasting tools such as momentum indicators, chart patterns, trendlines, support and resistance levels, etc. The trader must have the confidence to decide and trust his own judgment in this matter.
Focusing on the risk figure
It is important to approach the ratio calculation this way because of the dangerous habit that many traders have – entering trades solely based upon their expectation of reward. By placing the risk amount first it forces you to keep that figure preeminent in your mind during the trade selection process.
You don’t have to worry about being deadly accurate on the reward estimate now, just use your best judgment and technical indicators to come up with a reasonable estimate. You’ll never be able to determine the precise amount that the market will move. The important thing to remember is that you have firmly fixed your risk amount and based the ratio upon that number.
Risk = known quantity that is predetermined.
Reward = educated guess that is preferably 3x the risk.