Risk-Reward ratio

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Hey everyone!πŸ‘‹

Risk management is an essential part of successful trading as it helps in identifying, assessing, and mitigating potential risks that may arise from various factors such as volatility.

Whether you are a day trader, swing trader, or scalper, effective risk management can help you in protecting your capital, and minimising losses while maximizing potential profits.

Before we move ahead, please remember this is an educational post to help all of our members better understand concepts used in trading or investing. This in no way promotes a particular style of trading!

One of the key pillars of risk management is Risk-Reward (RR) ratio. Traders can use this concept for optimising their entries and exits.

πŸ“š What is Risk-Reward ratio?
β†’ The RR ratio measures your potential risk to the potential loss for a given trade.
β†’ A Risk:Reward of 1:3 means that you are risking 1 point in order to gain 3 points.
β†’ Conversely, some traders like to visualise it as Reward:Risk, in which case, the same proportion is written as 3:1.

πŸ” What's an ideal Risk-Reward ratio?
β†’ In general, some traders consider 1:2 or higher as a good RR ratio.
β†’ However, this is not written in stone and should not necessarily be taken at face value.
β†’ There is no β€œOne-size-fits-all” approach. Different traders have different systems and winning rates.
β†’ The risk-reward ratio combined with the win rate determines a trader's profitability.

🚨 Risk-Reward versus Win rate %
For a trader to stay breakeven,
β†’ A low RR requires a higher winning rate
β†’ A high RR requires a lower winning rate

As evident from the above data, a trader using a higher RR with a low win rate can still be profitable.

Hence, traders must combine their winning rate with an optimal RR to reach their desired profitability target.

Need for a balanced approach
β†’ A high risk-reward ratio seems attractive because it allows traders to make more profit than they stand to lose.
β†’ Similarly, a low risk-reward seems less attractive because it gives less reward as compared to the risk.

Example: Buying the horizontal breakout (Higher risk, higher RR)

Example: Buying the horizontal breakout (Lower risk, lower RR)

Risk is subjective and no two traders have the same risk tolerance. Therefore, it is advisable to use a RR as per your own trading system and the winning rate so as to ensure that the potential reward justifies the potential risk.

Thanks for reading! As we mentioned before, this isn't trading advice, but rather information about a tool that many traders use. Hope this was helpful!

See you all next week. πŸ™‚
– Team TradingView

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