Reward to Risk Ratio
To increase your chances of profitability, you want to trade when you have the potential to make 3 times more than you are risking.
If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run.
Example 3 to 1 Reward to Risk Ratio
In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000.
Just remember that whenever you trade with a good risk-to-reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.
On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios.
Let’s say you are a scalper and you only wish to risk 3 pips.
Using a 3:1 reward-to-risk ratio, means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread.
If your broker offered a 2-pip spread on EUR/USD, you’ll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward-to-risk ratio.
If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio.
Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips.
By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right?
In the real world, reward-to-risk ratios aren’t set in stone. They must be adjusted depending on the time frame, trading environment, and your entry/exit points.