Risk and reward on each trade

Measuring a trade in R

Traders have a handy trick. They measure every trade in units of risk, called R. 1R is how much you'd lose if your stop got hit.

From the last lesson: buy at $50, stop at $48, target at $54.

• Risk: $2 per share. That's 1R.
• Reward: $4 per share. That's 2R.

That's a risk-reward ratio of 1 to 2, usually written 1:2. You risk 1 to make 2.

Why this is powerful

If your wins are bigger than your losses, you don't have to be right most of the time. Here are 10 trades where you risk $100 to make $200 each time:

• 4 wins x $200 = $800
• 6 losses x $100 = $600
• Total: up $200, even though you were wrong 6 times out of 10.

How often do you need to win?

Here's how often you must win just to break even (before fees):

• 1:1 (risk $100 to make $100): win 50% of the time, 1 in 2.
• 1:2 (risk $100 to make $200): win about 33%, 1 in 3.
• 1:3 (risk $100 to make $300): win 25%, 1 in 4.

The bigger the reward compared to the risk, the less often you need to be right.

The catch

This sounds like free money. It isn't. A target that's farther away gets hit less often. If you set every target at 1:10, price will almost never get there, and you'll lose most of your trades.

So the ratio by itself tells you nothing. It only means something together with how often that kind of trade really wins. That combination is called expectancy, and it's the next lesson.

What goes wrong

• Grabbing profits early because you're nervous. If you plan for 2R but keep cashing out at half of 1R, your wins shrink while your losses stay full size. The math stops working.
• Picking a target with no reason. Targets should come from the chart, like the last high, not from wishing.
• Forgetting fees. Fees nibble at every trade, win or lose. A 1:1 trader who wins exactly half the time loses money once fees are added.

Remember

• 1R is what you lose if the stop is hit.
• Risk-reward compares the possible win to the possible loss. 1:2 means you aim to win 2 for every 1 you risk.
• At 1:2, you can be wrong more often than right and still come out ahead.
• Far targets get hit less often, so the ratio isn't magic by itself.