- Asymmetrical risk-returns can boost your gains and limit your losses significantly
- The greatest traders don’t take huge risks to make huge returns
What Is A Risk-Return Ratio?
In every trade you take, there are two possible outcomes: you either make money or lose money. One of the greatest skills you need to have to be successful in trading is how you balance these outcomes, or in other words, how much you can lose relative to how much you can make.
In financial terms, this is called the risk-return ratio, or the risk-reward ratio. In essence, a risk-reward ratio is just that: you bet a certain amount on a trade and you set up your trading strategy, not forgetting to include a stop-loss order and a take-profit order.
What a stop-loss order will do for you is cut your losses in case the position turns against you. This is your risk, or how much money you are willing to lose on the trade. And on the other hand, a take-profit order is the amount of money you expect to win, or your return.
How To Measure Risk Relative To Return
The risk-return ratio is best measured when you compare against your equity, or entire capital. How can you do that? You take your whole trading account, say you have $10,000, and you calculate your risk and return based on it.
If you open a trade with $100 and use leverage of 100:1 you control a position worth $10,000. Your job as a trader is to measure your risk relative to your return, and your final result should ideally represent how your trade performed relative to your equity.
On this note, you can measure return on equity, and not return on investment. Using leverage will greatly amplify your potential winning. If we took the above example, it wouldn’t be a proper assessment if you measured your return against your investment of $100. If you make $100 on the trade, you would have doubled your investment. Relative to your equity, however, you would have gained 1% to reach $10,100.
Example Of A Risk-Return Ratio In A Trade
While you can measure your investment results relative to your entire capital, you also have to align risk and reward yourself. Using the above example, let’s take your $100 and put them in the EUR/USD with leverage of 100:1. Now you have a $10,000 position and you expect the euro to rise in value against the dollar.
In more detail, a single pip would mean a move of $1 in your position. For 100 pips, or 1 cent, you stand to make $100. If your goal is to make $200, you will set your take profit order 200 pips above your entry-level. All that matters now is where you place your stop-loss order.
The level of your stop-loss order will determine whether or not your investment is asymmetrical. The closer it is to your entry, the less risk you take. And the wider your take profit order is, the more upside you can expect to gain from your trade.
What Is Asymmetrical Risk-Return?
And now we get to the essence. The most important thing in your trading setup is how far away your stop-loss is from your entry.
You’re still after these 200 pips, right? Now, imagine you place your stop-loss order 20 pips away from your entry. What you do is risk $20 to make $200, or 1 to 10. In other words, for every $1 you expect to make $10. This means you can be wrong 9 times out of 10 and still come out even.
Betting for asymmetrical returns is one of the quickest ways to reach financial freedom with trading. Let’s see how some legendary traders used this same trading approach!
Learning From The Greatest Traders
Most traders think you have to take huge risk in order to be successful in the financial markets. But the greatest traders who’ve made billions are doing the exact opposite. They shoot for asymmetrical risk returns.
For example, Paul Tudor Jones, a legendary trader worth over $7 billion, would only bet for asymmetrical rewards. He would look for investments where he believed that if he invested $1, he would make $5. The truth of the matter is that he, like many other traders, will be wrong lots of times. Nevertheless, Paul Tudor Jones knows that if he loses $1, he could risk another three and still be in profit.
“I look for opportunities with tremendously skewed reward-risk opportunities,” he says. “There’s no reason to take substantial amounts of financial risk ever. You should always be able to find something where you can skew the reward risk relationship greatly in your favor. That way you can take a variety of small investments with great reward-risk opportunities that should give you minimum drawdown pain and maximum upside opportunities.”
You Don’t Have To Bet The Farm To Win Big
When you strive to take the least amount of risk possible with the most upside, this is when you win two-fold. Not only do you protect your account from blowing up, but you also position yourself to make a lot of money. In other words, you don’t bet the farm to win big. Asymmetrical risk return allows you to play both great defense and great offence, ensuring that your trading will be flexible and sustainable.
Kyle Bass, another prominent investor, took $30 million in 2009, in the heat of the global financial crisis. He turned these $30 million into $2 billion in just two years. He never risked more than $0.06 to make a $1; he could be wrong 15 times and still break even.
Once you realize the potential that asymmetrical risk-return gives you, you will be in control of your trading regardless of market conditions. You can employ this approach to any market, from stocks, to crypto, to currencies and so on.
“If you have made a mistake, cut your losses as quickly as possible,” said legendary financier Bernard Baruch.
When you go out in the market, you encounter a whole new set of emotions that can influence your decision making. The best way to approach everything that’s going on is to have a robust trading strategy in place. For example, plan to cut your losses early but let your profits run.
This is another way of explaining how asymmetrical risk-return works. Letting your profits run is as essential as cutting your losses early, and armed with both, you’ll be in your best shape to enjoy tailwinds as well as face headwinds. When a trade is going your way, you might be tempted to sell it too early, so it helps to have an end goal and set this as your take profit if you truly believe price will get there.
On the flip side, if a trade turns against you and is making you feel uncomfortable, get out. You can always get back in, even at a lower price level.
Betting for asymmetrical returns is one of the most important trading principles. It’s practical and can be used everywhere. For your part, you need to decide what you personally consider a fair risk-return ratio. You could opt for 5 to 1 and risk $1 to make $5, or you could go higher and risk $1 to make $15.
To properly assess your risk-reward ratio, keep in mind the vision you have for your trading journey. At ThorFX, we offer the most popular markets and enough leverage to reach your goals as quickly as possible.
In addition, you can check our forex compounding calculator and get an idea how much return you need per month to get to a certain amount of money. Forex trading, for that matter, is one of the most well-suited markets to practice asymmetrical risk return trading.
In conclusion, the exact risk-reward ratio is up to you to decide. Markets will be here so there is no need for you to rush. Simply aim to stay in the trading game as long as possible; shooting for asymmetrical risk returns is one of the surest ways to do this.
What Is The Risk-Return Ratio?
In every trade you take, there are two possible outcomes – you either make money or lose money. One of the greatest skills you need to have to be successful in trading is how you balance these outcomes. In other words, how much you can lose relative to how much you can make.
In financial terms, this is called the risk return ratio, or the risk reward ratio. In essence, a risk reward ratio is just that – you bet a certain amount on a trade and you setup your trading strategy. You put a stop loss order and a take profit order. That way your stop loss order is the risk you take, whereas the take profit order is the return you expect.
What Is An Asymmetrical Risk-Return Ratio?
A risk return ratio that is tremendously skewed in your favor is called asymmetrical. In other words, you put a tight stop loss order of 10 pips, for example, and a wide take profit order of 100 pips. That way you have a risk reward relationship of 1 to 10. This means you risk $1 to make $10.
How To Measure Risk Relative To Return?
The exact risk reward ratio is up to you to decide. You can opt for 1 to 5 in terms of risk to reward. Or you can go higher and expect more profits for less risk like 1 to 15. You control these variables by setting stop loss orders and take profit orders.