March 18, 2021

Best risk reward ratio for day trading

Applying risk management is crucial as a beginner

The chances are that you have heard or come across the word term risk reward ratio at one time or the other in your day trading journey. If you haven’t and are trading without one, it won’t take long until you run your account aground or run into a brick wall. Having mentioned that, the million-buck question is what is the best risk-reward ratio for day trading?

As the name already implies, the risk-reward ratio compares your potential profit and loss on each trade you execute in the financial markets — be it stocks, options, or futures market. To calculate the risk/reward on your trades, you must establish the difference between your entry point or price and stop-loss (this forms the risk part of the ratio).

Another area of interest for calculating your risk-reward ratio is yeh difference between your entry price/point and takes profit target – and yes, you guessed right. That is the reward part. Dividing the risk by the reward gives the risk-reward ratio — R/R ratio.

What is the risk-reward ratio?

As we mentioned earlier, the risk-reward ratio measures the potential reward a trader stands to gain from his or her trade. And it is relative to the potential loss or risk such trade presents. Recall that a stop-loss order is used to measure the risk while the profit target gives an estimate or idea of the potential reward or profit.

If you missed our last post on what a stop-loss order is and how it works, let’s quickly fill you in. A stop-loss order is a market order that automatically sells a security or financial asset if the price drops to a certain value or amount. Thereby, minimizing the potential loss you would incur if you had remained in a losing trade.

Having mentioned that, the relationship between the differences between your entry points, your stop loss, and profit target will paint a clear picture of whether the potential reward on a certain trade outweighs the potential risk. That way, day traders can make informed decisions before taking any trade.

How do you calculate the risk-reward ratio?

Contrary to popular misconceptions, calculating the risk-reward ratio is not rocket science. All you have to do is figure out both the risk and rewards and you are done. However, it is not a one–size –fit–all thing because different traders, depending on their trading strategy and also the size of their trading account, adopt different risk-reward ratios.

Going by popular convention, if the risk-reward ratio is greater than 1.0, it implies that the potential risks outweigh the profits. On the other hand, if the ratio is less than 1.0, it means that the potential reward on trade is bigger. Not to bother you with trading jargon, here is the risk-reward ratio in action. Suppose you buy a stock at $25.60 ( your entry point/price) and proceed to place your stop loss at $25.50 and take profit/profit target at $25.85, your risk-reward ratio can be calculated as follows:

The risk is is $0.10 ( $25.60 — $25.50) while the reward is $0.25 ( $25.85 —$25.60). Your risk-reward ratio will be $0.10/$0.25 = 0.4. Hopefully, you understood that. If you did, what will be the right conclusion? The trade is a profitable one because the ratio is less than 1.0.

What is the best Risk/reward ratio?

As we mentioned earlier, there is no universal definition for the best risk-reward ratio for day trading. However, from experience and active years of trading, it is advised for traders to opt for trades with a lower risk-reward ratio as we have demonstrated earlier. While you are it, bear in mind that that the ratio doesn’t have to be very low to work– A risk ratio between 1.0 and 0.25 is okay for most traders.

Generally, most day traders, swing traders, and investors sit on their hands when they cross paths with trades that offer less profit potential. With so many opportunities building up in the market, the last thing any trader wants to do is take on more risks for peanuts. Mind you, the choice of risk-reward levels is not done at random. These levels should be guided by both logical and market analysis.

Are there any limitations on the risk-reward ratio?

When talks about the best risk-reward ratio come to the fore, one question that often trails it questions about its limitations. A low R/R ratio doesn’t present you with all you need to know about trade. You must do due diligence and research the likelihood of your trades hitting their target under different market conditions.

One common mistake that most day traders make is that they approach every trade with the same risk-reward ratio in mind. Having a risk-reward ratio in mind before analyzing the market structure and trend will most likely result in a gambling-style trading situation because you will be placing your targets blindly ( by placing your stop loss and take profits based on your entry point instead of the value if the asset you are trading and prevailing market conditions).

Choosing the best Risk reward ratio

When it comes to choosing the best risk-reward ratio for day trading, one has to strike balance between taking trades that offer the best reward potentials and have more chance of reaching the profit target compared to stop loss.

While you are at it, your trading plan should establish what the current market conditions are, give pointers on your entry and exit points and tell you where reasonable stop loss and profit targets under the prevailing market conditions. If you check all of these boxes, choosing the best risk-reward ratio for your trades becomes relatively easy.

Rounding off of the subject. The decision of whether a trade is profitable or not shouldn’t be based on the best risk-reward ratio for day trading alone. There are other factors you should consider adding to your checklist. They include the win/loss ratio and of course, the break-even percentage. While the former tells you the number of winning trades compared to losing trades, the latter tells you how many winning trades you need to score to break–even.