I've seen references to a 3-to-1 risk/reward ratio as a good target in several posts (for example: http://www.elitetrader.com/vb/showthread.php?s=&threadid=14617&highlight=risk+reward+ratio). The definition I found was to divide the expected return by the std dev, which means that people are expecting a 3% gain with a 1% std dev. Is this accurate? This seems WAY to optimistic to me, because under a normal distribution curve, two standard deviations from the mean of 3% would mean that 98% of trades are equal to or better than 1%! I'm thinking that some people are flipping the numbers around. Can someone please clarify this for me?
I think that I would have to agree ... that in reality I find that most of my trades do not reach their expected profit target. Therefore when an expected profit target is 3 to 1, actual trades result in 2 to 1 or even 1 to 1. Realizing this fact is not reason enough to discard the trading system as long as the systems' winning percentage is high enough to make the system worthwhile over all. For example if the system results in 2 to 1 risk/reward ratio, and the winning percentage is 75% and net profits average $20,000 per month then what you have is a dynamite trading system! On the other hand if the system only makes $1,000 per month, its time to make some changes. Overall results are the determining factor, not winning percentages or risk/reward ratios.
Your formula is completely different from the definitions that I've found on financial sites (which universally define it as expected return divided by standard deviation). Do most traders on this forum define risk/reward ratio the same way as fan27? I hope I'm not drilling an irrelevant point, but I want to be sure I understand the terms that people are using on this forum.
risk is defined by stop loss order, or by the total size of the position, very straight forward. reward is a bit fuzzier and is based upon whatever method of analysis you happen to use.
How can you define the risk as EITHER the stop loss order OR the total size of the position? Aren't those are two completely different numbers? Doesn't seem straightforward to me. I'll just assume that fan27's definition is how members are calculating it, which appears to be a ratio that fan27 HOPES to achieve. However, if referring to historical results, I'll assume the the R/R ratio is a calculation of the average gain divided by the average loss. Anyone out there, please let men know if you calculate it any differently.
I calculate Risk/Reward as follows: Risk is the amount from my intended entry to my stop loss. How many points (not $) I'm willing to give up to take the trade. Reward is the potential target where I think the trade may have run it's course. For me this is discretionary, based on support/resistance, technicals, etc. I look for a 3:1 ratio of reward to risk to consider taking the trade. If you have a high success rate then 2:1 will do fine. As a separate issue I decide how much size to trade: I use 1% of equity as my $ risk per trade. For example, I've got $50K so I'll risk $500 on a trade. If my stop is 1.50 then I'll trade 500/1.50 = 333 or approximately 300 shares (using stocks as an example). If you trade often you may only risk 1/2% per trade. If you trade every few days/weeks then 2% might work for you. The risk/reward for a trade and how much you put on the trade are separate issues. The former concerns "Do I take this trade?" and may prevent you from wasting your time and money. The latter, if you decide to take the trade, determines how much you may win or lose and is very important to your survival as a trader. There are a lot of variations to this, but they only differ slightly from the basic concepts. However, one important caveat, for those of us with margin concerns who trade multiple positions, is portfolio risk. I may want to cap the number of shares I trade, again using stocks, to some maximum percentage of my equity. This would prevent "putting all your eggs in one basket". Using the above example where my size was to be 300 shares, if that's a $150 stock then my total position would be $45K, or 90% of my equity. I would reduce size, or skip the trade entirely, in this case. I hope this helps. Van Tharp's "Trade Your Way To Financial Freedom" book is a good primer.
Okay, let's define risk and reward: (layman's terms) Risk is calculated as the total amount of dollars lost when total position is stopped out for a loss. Reward is calculated as the total amount of dollars gained when total position is closed.