To understand the risk reward ratio requires some knowledge of ratios in general. A ratio is a quantitative relationship between two numbers. It shows how many times one value is contained within another. For instance a ratio of 1:3 means that 1 is contained 3 times within 3.
A favourable risk reward ratio in spread betting or any other kid of trading can mean the difference between success and failure. For instance if you have a risk reward ratio of 1:1 you would be only making your risk back (if you win) and therefore you would need far more winners than losers to make a profit. That’s fine if you can predict the markets. The fact is no one can. Therefore you are better of aiming for a more favourable risk reward ratio.
Some people suggest 1:2 or 1:3 risk reward ratio. These are better ratios to aim for as a risk reward ratio of 1:3 means you can be wrong 70% of the time and still make a profit.
The following example assumes a risk of 10 to a reward of 30. Therefore a 1:3 risk reward ratio.
| Trade1 | -10 |
| Trade2 | -10 |
| Trade3 | -10 |
| Trade4 | -10 |
| Trade5 | -10 |
| Trade6 | -10 |
| Trade7 | -10 |
| Trade8 | +30 |
| Trade9 | +30 |
| Trade10 | +30 |
This gives a total of -10-10-10-10-10-10-10+30+30+30 = 20
If you made these 10 trades with a risk reward ratio of 1:3 you would come out with an overall profit of 20. Therefore the strategy that you use only needs to be right 30% of the time to make a profit.
This all sounds great but it’s not quite that straight forward. First you will need to develop a strategy that offers a 1:3 risk reward ratio. The fact is you can try and develop one but you cannot guarantee a 3x risk result every time or even 30% of the time. It’s a good idea to have a risk reward ratio to work to but if a position is in profit then why would you want to exit if the price is still rising? The better thing to do is aim for a minimum of 1:3 risk reward ratio but if a price is rising then let it run and run and run. That way you will not need to be right 30% of the time to make a small profit, there is a chance that you can be right fewer times and make big profits. You may even hit a risk reward ratio of 1:10, 1:20 or higher.
