TradeCityPro Academy | Risk to Reward👋 Welcome to TradeCityPro Channel!
Let’s dive into another educational segment. After discussing capital management and risk management, we now turn to one of the most crucial concepts before entering technical analysis: Risk to Reward!
📌 Understanding Risk-to-Reward in Real Life
Before we start, let me give you an example of risk to reward from the real world, outside of financial markets. Imagine you are considering investing in a startup technology company that has launched a new product.
Risk: You estimate that you might lose $500 of your investment due to uncertainty about the product's success and intense market competition.
Reward: However, if the product succeeds and the company grows, you could make a profit of up to $2000.
In this example, the risk-to-reward ratio is 1:4, meaning for every $1 at risk, you could earn $4 in reward. This ratio can help you decide if this investment is appealing. If you believe the risk is acceptable and the potential reward is valuable, you might choose to invest.
⚠️ The Reality of Risk-to-Reward in Trading
In the real world, if you are a logical person, we all adhere to risk to reward principles. However, it’s puzzling how, in financial markets, you often close your profitable trades as quickly as possible while staying in losing trades for months. This indicates a failure to adhere to risk to reward principles.
Before I explain risk management and related concepts, make sure you've viewed the previous sections on risk management and capital management. Remember, if you're not setting stop-loss orders, this lesson might not be very useful for you.
🔍 What is Risk-to-Reward in Trading?
In financial markets, risk to reward refers to the ratio between the level of risk an investor takes with a specific investment and the potential reward from that investment. This concept helps investors evaluate whether a particular investment is worth the risk.
When trading, if you are about to open a position, set a stop-loss. If your stop-loss is triggered, resulting in a $10 loss, your target profit should be at least $20, creating a risk to reward ratio of 2. I won’t open a position with less than this!
It's important to note that risk to reward alone doesn't hold much meaning. It gains significance when considered alongside win rate. The chart I will share clarifies the relationship between win rate and risk to reward.
Look at the chart below. If your risk to reward is 1 and your win rate is 50%, you are breaking even—neither gaining nor losing. For risk to reward ratios below 1, you need a win rate of 100% to break even. Our logical risk to reward ratio is 2, where a 40% win rate keeps you profitable. We should allow our minds room for error rather than always striving for accuracy.
🛠️ Understanding Trading Tools
Let’s take a simple look at our tools. The chart showcases two types of tools: short position and long position, applicable for both falling and rising markets. The tool displays your risk to reward ratio in the middle, with the stop-loss percentage below and the profit percentage above for long positions, and vice versa for short positions.
📈 Why Should You Use a Risk-to-Reward of 2?
Why do you implement a risk to reward of 2? Consider this: if I opened 10 positions this week, with 6 hitting stop-loss and 4 reaching targets, my total loss would be $60. However, due to adhering to a risk to reward ratio of 2, my total profit would be $80, resulting in a net gain of $20!
This illustrates the importance of adhering to risk to reward principles. Even if we lose more trades than we win, we can still be profitable in the end. The key is to focus on the overall outcome rather than individual battles.
❌ What Happens If You Don’t Maintain a Standard Risk-to-Reward?
Now, consider what happens if I don’t maintain a standard risk to reward. For instance, if I open a position with a risk to reward ratio of 0.5, even if I make a profit, a subsequent loss could negate that gain.
If you are involved in financial spaces, you may have encountered signal channels that share their positions, encouraging you to follow for profitable outcomes. For example, if they claim to profit from 95 out of 100 positions, you might feel that winning sensation. But what is their risk to reward ratio? A ratio of 0.1 means that if they hit just a few stop-losses, you could end up in a loss.
Be cautious of misleading advertisements and high-return claims. If you manage to achieve a 5% to 10% profit monthly and sustain it for a year, even starting with $100, your trading record will be respected, leading to more funding opportunities. Avoid falling into traps set by opportunistic individuals.
🚀 Practical Trading Considerations
Consider this: if you want to open a position but your target is above a major resistance level, and the likelihood of reaching it seems slim, I personally prefer not to open that position. It indicates that my entry point may not be optimal.
❤️ Friendly Note
In closing, I encourage you to keep your positions until you reach your risk to reward target. Avoid checking the chart until you hit that point. Set alerts and make decisions only then. Always adhere to these rules for all your positions, not just one. Don’t worry about losing out on profits; instead, approach trading with calmness.
Finally, remember that a profit in a position is not truly realized until it is closed and transformed into something tangible—food, clothing, a house, or a car.
