Capital management is the most important thing when you invest or operate in the stock market. Within management systems there is much talk of risk benefit relation. How much are you willing to lose to win a certain margin. For example, I am willing to lose 0.50% of my capital to earn 2.00%, this would be a risk benefit ratio of 1:4. I am willing to risk a dollar to gain $4, to write it in simple terms. Traders typically make this relationship using points, pips, dollars, etc., which is incorrect. It is a very common mistake because the instruments we trade do not always have the same value per point or per pip; therefore, the risk-benefit return will not always be the same. I recommend you calculate the risk-benefit based on a percentage as indicated in the example.
The correct relation between risk benefit
Many traders often use ratios as 1:1, 1:1.5, 1:2 when trading or just don’t use them at all. A risk benefit ratio is used to protect the capital, so that in the long term you do not lose it. But which of these ratios is correct? For that, we must use a statistical concept called Mathematical Expectation. The mathematical expectation, also called the expected value, is equal to the sum of the probabilities that a random event exists, multiplied by the value of the random event. In other words, it is the mean value of a data set.
With this concept we have created a table where we compare the number of successful operations vs the risk/reward ratio (R:R):
On the left side we have the percentages of success and on the top the R:R ratio. The percentages in red are losses and in blue are gains. The value of the percentages is the long-term profit if you were risking 10% of your capital per trade.
We can see that if we have 50% of winning trades and we always use a 1:1 ratio, the profits would be 0%. In the table, we are not considering commissions or rollover. This means that if you have 50% of winning trades with a 1:1 ratio, the result is long-term losses.
What happen with scalpers? A scalper typically has an inverse risk-reward ratio. He is willing to lose more for a small profit. For example, 10:3 or 2:1. If we see the 2:1 ratio in the table, it means that the trader must win 70% of the time in order to generate profits.
We can continue navigating the table. Let’s look at a 1:1.5 ratio. This tells me that in order to make long-term profits I need to have at least 50% winning trades. If we use a 1:1.8 ratio, we need 40% winning trades to make a profit in the long run. Therefore, the better the R:R ratio, the fewer hits you need to make a profit.
How to know what our best risk-benefit ratio is? Well, you must try. If you start with a 1:1 relationship and after 10 trades you only have 5 winning trades, it is not for you. You have to raise the R:R ratio. If you get your ratio up to 1:1.5 and still keep the number of winners at 50% then that R:R go with you. And so, you continue to raise the R:R ratio until the number of hits goes down and then you compare it. Example: You raise the ratio to 1:2 and the number of winning trades drops to 40% does not go with you, compared to the ratio of 1:1.5. With a 1:1.5 ratio you have a 25% return, but with a 1:2 ratio you have a 20% return.
You must continue testing until the ratio 1:3 at least to know what your number of winning trades is. It is possible that by increasing your ratio to 1:2.5, your number of hits will remain at 40% which would result in a 40% return in the long term, much higher than the 25% of the previous 1:1.5.
The answer to the question, what is the correct risk benefit ratio for trading? It depends on each one. Try and become a real professional trader and don’t be just another gambler. Start looking for the risk-benefit ratio so that your operations have the highest possible return. Do not forget to calculate your risk benefit based on percentage of capital.
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