Knowing the Three “R” of Successful Traders
There are so many things that a trader has to do while being successful. For example, “trading psychology,” technical analysis, appropriate strategy for trading, and being able to distinguish between trader/investor. However, the risk-reward ratio (RRR), a fundamental concept, works in the heart of every trade, yet many traders (particularly new traders) do not know about it. Or even if they know, they do not know how to apply it. This blog is focused on the concept and importance of the risk-reward ratio.
Risk-Reward Ratio (RRR): The Concept
The risk-reward ratio could be explained in several ways. But perhaps the easiest way is to understand it to the analogy of a fisherman working on his catch. Imagine a fisherman sitting on a riverbank, and he wants to place his bait on his hook to catch a fish. His bait should be smaller than the fish he catches. If he catches smaller fish with bigger bait, his catch/efforts are no use.
Image by Michal Dziekonski from Pixabay
The fisherman analogy may be applied to the risk-reward ratio (RRR). RRR refers to how much you will gain for placing $1 at risk. Or, in other words, how much you can gain by risking one dollar.
For example, if you lose a $1000 trade and incur a loss of $10 while you hope to earn a return equal to $20. It means your risk-reward ratio was 10-20 or 1:2. It implies that you were risking $1 against every $2 you could win. The reward must always be higher than the risk (catch should be larger than the bait). If you keep risk and reward equal, you stay on breakeven.
How Risk-Reward Ratio Help Traders?
RRR is a critical consideration for a successful trader. First, it lets you help to decide if a particular trade is worth taking. For instance, you should only be selecting trades that give you significantly higher rewards than the risk you are willing to undertake. Secondly, it helps you choose the “capital size” that you must put in a particular trade, i.e., you can use it to calculate the “position size” for every trade. Thirdly, it helps you keep your trades within the manageable risk. Thus, it allows you to minimize loss if you have a losing trade. Therefore the application of RRR becomes very helpful for future/margin traders to avoid bankruptcy.
The most important use of RRR is the cashout of profit. Just like loss minimization, RRR helps you cash out your profit. Traders (especially the new traders) wait for the markets to go up and touch the highest possible point to earn the maximum possible profit. However, in this “wait,” they mostly miss the opportunity to cash out a profit. The market never goes straight up or straight down for a long time. So, while the trader reaches a certain level of profit, and meanwhile, the market does “little corrections,” traders take it as a brief moment (as the market always does that). They expect that the market will revert and go up again. But instead, the market goes down further; thus, the profit they were initially able to earn reduces. Now, they wait further, thinking that they may earn the earlier profit (which they did not cash out at that time), which is higher than they can get now with existing market conditions. However, the market goes further down, and ultimately, they are back to the same position where they started, or sometimes even worse, the trade may turn from profitable to lose the trade. In the case of a defined RRR ratio, before entering in trade, traders know when to exist if a trade is in loss and when to cash out a profit if a trade is in profit.
In summary, setting RRR is like placing a clearly defined system of “entry” and “exist” to market. It clearly defines if a trade goes in loss, how to minimize loss, and if a trade is in profit, at what level the profit can be cashed out. RRR combined with position-sizing brace traders to make successful trades.
Dr. M. S. Afridi