# How to use Risk-Reward Ratio in Trading?

The earlier blog was on introducing risk-reward ratio (RRR) in trading and highlighting its importance for traders. The current blog focuses on the use of risk-reward ratio in trading. The focus is on the practical application of the risk-reward ratio in trading.

### How to start with applying Risk-Reward Ratio in Trade?

Let’s start with new traders who have no idea how to use the risk-reward ratio. It’s important to highlight that the risk-reward ratio cannot be used in isolation. Several other things must be considered along with RRR to take maximum benefits from trades. Therefore, we will assume some numbers to make it more realistic.

A small retail trader has 2000$ capital to make to trades. So how can that new trader use the risk-reward ratio to ensure maximum profits from his trades? To use RRR, the trader must also be familiar with the 1% rule (we recommend reading our earlier writing on it) and the position size. i.e., while setting risk-reward for a trade, the trader needs to know how much he can invest in keeping losses by up to 1% of total investment. With 2000$, in a single trade, he can lose only 20$. So whatever trade setup he is making/setting, he should not lose more than 20$.

Now imagine. There is a coin that has an entry price of 15.99$. The trader did some technical analysis, and he knows that the coin price is expected to rise to 16.41$ (2.63% rise); at the same time, the coin has a risk of going down to a lower resistance level (at 15.78$, which is 1.31% fall), as shown in Figure. The trader needs to know his Risk-Reward Ratio from this setup and if it is “worth enough” to get into this trade.

**Figure ***Trade setup for Risk-Reward of 1:2*

In the current case, the traders first need to calculate his position size from his total portfolio (2000$) by dividing it with his calculated risk (i.e., 1.31%). It implies that he should invest 1527$ (2000/1.31 = 1527$) rather than his total capital. If he loses this trade, his loss will be 20$ (1527 x 1.31% = 20$, equal to 1% of his total capital of 2000$). If he wins the trade, his profit will be 40$ (1527$ x 2.63% = 40$). Thus, when he risks his single dollar, he will earn 2 dollars.

### What Risk Reward Ratio to Set for a Trade?

Imagine that a trader is new and is taking the risk of 1% per trade only (i.e., not going to lose more than 1% of his total portfolio in a single trade). What is the ideal risk-reward ratio for a new trader (or a trade-in general)?

A rule of thumb is that risk should always be lower than the reward (or reward should always be greater than the risk). Because the catch should always be greater than the “bait.”

Secondly, how risk-reward ratio can be helpful if a trade (or several trades) goes in loss? The risk-reward ratio gives you an idea of how many trades from a series of trades you can lose to be on breakeven or to stay profitable for a certain fixed risk-reward ratio.

For example, imagine the above example, in which the trader kept his risk-reward ratio to 2 (or 1:2), and if he lost that trade, he would lose the first trade. It means his capital of 2000$ will reduce to 1980$, one another such loss in trade will further reduce his portfolio to 1960$ if he keeps his risk-reward ratio to 1:2 and follow 1% loss principal. But if he wins the third trade, with the same risk-reward (1:2), 1% loss principal, and 1960$ total portfolio, he will earn 40$, which will bring him back to his original capital level of 2000$.

Thus, with a risk-reward of 1:2, you need one win in every three trades to be on breakeven, and if you have more than one win in three trades, you will make a net profit. If you take 100 trades and have a risk-reward ratio of 1:2, you only need to win 33 trades (out of 100) to break even. But if you win more than 33, you will be in net profit. Setting an appropriate risk-reward ratio for a trader depends on the traders’ success rate. Trader success rate requires more details that will be shared in the context of risk-reward ratio in a separate blog.

### Relationship Between Number of Trades, Risk-Rewards and Trade Outcome

Table 1 presents a relationship between risk-reward and breakeven/profitability in 100 trades. If a trader takes 100 trades and keeps his risk rewards at 1:1, then he needs to win at least 50 trades to be at breakeven. If he wins more than 50 trades, he will make a profit.

**Table 1 ***Minimum Trades (out of 100 trades) required to break even and make a profit*

Minimum Trades (out of 100 trades) required to break even and make a profit

The power of the risk-reward ratio can be understood better by the following example. If a trader plays safe and keeps risk-reward at a low level such as 1:2, then that person needs only 33 trades to win out of 100 to stay in breakeven (despite the fact if he loses the remaining 67 trades). If the trader wins the 34^{th} trade, he will be in net profit, and further wins mean more profits. However, please be informed that these calculations are based on a fixed risk-reward ratio for 100 trades and only 1% fixed loss for all 100 trades.

Written by

Dr. M. S. Afridi