R:R Ratio – The Unintended Red Herring
The Reward Risk (R:R) ratio helps a trader manage his trade – not provide a valuation of risk. R:R does not measure risk. Some strategies with “inferior” R:Rs are in fact safer (less risky) than some with higher R:Rs.
A highly positive R:R ratio falsely assures many traders a risk is worth taking. If someone passing by my house tells me there is a large, hopeful gold vein in my backyard and shows me geo-studies attesting the same, should I invest a handsome amount towards mining it? The R:R ratio can grow higher as gold prices climb, but that does not in any way change the risk of my mining efforts returning nothing.
Recently someone signaled a buy trade to me with a 1.5 R:R ratio. Having only a 20 pip stop, her call was subject to short term volatility of the traded pair. With a rational edge (Strategy: London open plus confluences breakout), she was confidently calm and collected. Whether she lost or gained that day was immaterial. She was undaunted. Mathematically, she would still be ahead even if she lost more times than when she profited. By smartly managing her position sizes, she supposedly stood a good chance of winning over the longer term. Where was the risk? If she had a wanton run of bad luck? That would hardly be the case – since most traders are self deluding to some extent – we just don’t believe bad luck can consume us. I would have applauded her but for….
My quibble was not her sanguinity with losses and wins, nor her tight money management wisdom. Rather I chided her for not taking an opportunity only when conditions were most favorable. Her trading position was not initiated until several hours after her call. Her edge had already diminished significantly by then. Naturally her premeditated stop loss became too tight as the trade progressed into a more ruthless, volatile Europe / US crossover time zone.
But she staunchly waited for her 1.5 times target. In that latter session, there were additional risk events (two important scheduled announcements) that could have easily swung her out. Could she have closed her position rather than wait for the 1.5 R:R target? Rephrasing this – if the major, volatility inducing announcements were scheduled earlier around the London open instead, would she still have stuck with a 20 pip stop strategy? If she would not then, why would she still risk an “outdated” strategy in the harshly volatile US/Europe crossover? I asked her, and she justified she had an advantageous R:R target. Even if the R:R was raised 4 times, her initial strategy was already obsolete for the change in risk. Any lucrative R:R could not justify a wrong strategy that did not match the risks involved.
With an attractive R:R ratio, many traders can answer “Is this a favorable trade?” but forget to ask “Is this a high probability trade?”.
There is no recommended range for R:R ratio. Some strategies are only successful with low R:R targets. Others may only be tenable with lofty R:R ratios. R:R ratio is just one of many very important contributors to risk management. But more often than not, it becomes an excuse for impulsivity, hope and greed.
PS: Thankfully she did hit her R:R target later. I on the other hand, saw the opportunistic clues provided by her failed strategy near the London open, plastered with other market developments, took the cue to short sell another pair. My R:R ratio was 1:1, but I got my 20 pips profits within 30 minutes with an efficient edge and a lot less risks.