What is Asymmetric Risk-Reward – An Imbalance in Potential Loss and Profit:
Asymmetric risk-reward is simply when risk is not equal to reward. For example, a trade that offers a $300 potential profit for $100 of risk has an asymmetric risk to reward ratio of 3:1. Generally speaking, a 3:1 ratio is the “sweet spot” for most traders/investors.
Note: “risk-reward” is the usual way the terminology is stated, but when the numbers are stated – it’s typically the opposite (units of reward first and risk second). So a 3:1 risk-reward ratio means the reward is three times the risk.
The reason for having a higher potential reward in comparison to risk is so that you don’t have to “win” as often on your trades in order to be profitable long-term. With a 3:1 risk to reward ratio, for instance, a win percentage over 25% makes you profitable.
Of course there are trading commissions and fees to consider, so you’d probably have to have a win rate at least a couple percentage points above 25% to actually be profitable. But many highly-profitable traders have win rates in the 40-60% range.
Non-traders, as well as new traders, don’t typically view a 40-60% win rate as “good” because they’d rather be “right” more often (have a higher win rate) and don’t know how the math works. But you can make a lot of money with a 40% win rate and 3:1 risk-reward.
If we plug these numbers into the expected value equation, we see that they produce an expected return of $60 per trade. If you’re a day trader who makes roughly 5 trades per day, this can add up to some real money over the course of a year or two.
Expected Value/Return = (Probability of Winning x Average Win) – (Probability of Losing x Average Loss)
E = (40% x $300) – (60% x $100) = ($120) – ($60) = $60
This doesn’t even consider a potential increase in size – like risking $1K for $3K reward – which would produce an EV of $600 per trade.
Keep in Mind – You Can’t Just Create Risk-Reward Asymmetry Out of Thin Air:
Trading is very subjective. There are millions of market participants using various indicators, strategies, systems, tools, and methodologies across numerous time frames. So nobody can tell you exactly where your stops and profit targets should or shouldn’t be.
But keep in mind that you can’t just create risk/reward out of thin air. It should be based on context (whatever that means to you and your specific trading methodology). Just because a stop and profit target are in place doesn’t mean the potential R/R is “real”.
For example, if I open up my brokerage account and choose a random stock (let’s call it ABC), buy it at market price (let’s say $5), put a stop loss order in at $4, and my take profit at $105 – that would be a massive risk to reward ratio of 100:1. Sounds nice, right?
But is this risk to reward ratio real? Is ABC stock really offering me a 1:100 risk-reward opportunity or am I just “hoping” for a miracle? Is there anything from a technical or behavioral perspective telling me that my profit target is realistically achievable?
So the risk-reward ratio on a given trade isn’t just what you want your stop loss and profit target to be. These exit areas should be based on market-generated information (like key price, volume, and time-based support and resistance levels/zones).
5 Potential Trade Outcomes and the 1 You Need to Eliminate ASAP:
This is a fairly basic concept, but I think it ties in nicely with risk-reward ratios and the expected value formula.
After entering a trade, there are essentially only 5 possible outcomes:
Large Loss → ELIMINATE
If you can eliminate #5 (large losses), then you have a much higher chance of being profitable long-term. Of course, doing this is much easier said than done. But it’s extremely important because big losses are detrimental on both a financial and psychological level.
It’s fairly common for traders to look at their personal trading statistics and discover that if they were to just eliminate their large losses (and stop out when those losses were small), then they would actually be profitable. Sometimes it can be that simple.
To Be a Trader is to Be a Good Risk Manager – A Practitioner of Uncertainty:
To wrap things up, most consistently profitable traders implement strategies/systems/methodologies with asymmetric risk-reward.
It’s not required (some traders are profitable with a 1:1 risk-reward ratio), but that means they have to maintain much higher win rates to be profitable (over 50%). And as many with experience trading know, it’s not all that easy being “right” that often.
Many people equate trading to predicting/forecasting. But there’s no way to predict the future with 100% certainty. All we have to work with are probabilities (not certainties) – and then we try to monetize those probabilities through a risk-reward process.
To provide an illustration of what I mean by this, let’s say (theoretically speaking) that based on my data/research there’s a 95% chance of the market continuing to climb higher and just a 5% chance of it descending into a bear market within the next month.
Based on my research, it’s clear that my prediction would be for the market to climb (95% is a high probability). But I haven’t yet considered the potential magnitude of the two moves. What if there’s 50X more profit-potential in the bear market scenario?
If that’s the case, selling the market in this situation (even though there’s only a 5% chance of it working) might actually be worth the risk. So it’s not just the probabilities that matter, but the magnitude of the risk/reward inherent within the situation as well.
Learn More in the Trading Success Framework Course
Written by Matt Thomas (@MattThomasTP)
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- What is Trading Expectancy – The Importance of Having a Statistical Edge