Best Risk Reward Ratio Day Trading
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Using the best risk reward ratio in day trading can make a whole difference regarding profitability because managing risk is key to success as a day trader. The best possible risk management helps day traders keep losses on the smaller side while making money from winning trades.
This guide details the risk reward trading concept and the best ratios for day trading.
Why Risk Management Is Important
Day trading is more than just placing buy and sell orders frequently throughout the day. As a business owner, you need a plan. As an investor, you need a plan, and as a day trader, it is even more important to have a trading plan. And the definition of how much you risk per trade, the profit potential, and the expected win rate are key parts of your trading plan.
With every day trade you make, you manage risk. You always aim to make more money with your winners than what you lose with your losing trades.
What Is the Risk Reward Ratio
The risk-reward ratio indicates how much risk you are okay to take in order to get your specific reward. Translated to day trading, it means how much money you are okay with losing with your trade in order to make the intended profit with that trade.
The risk part of the calculation is your trade entry minus the stop loss level. The reward part of the calculation is your profit target minus the trade entry price.
Example Long Trade:
You go long at $100. You set the stop loss at $99, and your profit target is $105. In that case, your risk is $1, your reward is $5, and the risk-reward ratio is 1:5. So, for every dollar you risk, you aim to make 5 dollars.
Example Short Trade:
You go short at $100. You set the stop loss at $101, and your profit target is $95. In that case, your risk is $1, your reward is $5, and the risk-reward ratio is 1:5. So, for every dollar you risk, you aim to make 5 dollars.
Best Risk Reward Ratios
The internet is full of concepts of the best risk reward ratios, covering how to apply them and indicating how they help you make millions per year. But often, it seems that those who write something like “use a 1:10 risk reward ratio, and you will become rich overnight” never really thought through the topic.
Let’s say you use a 1:10 risk reward ratio. You apply the rule and stay strict with that rule. Even if a trade is already on a 1:9 risk reward ratio with the current price action, you wait to make the 1:10 no matter what?
Well, this is not a good approach.
Imagine you make 10 trades using the 1:10 risk reward ratio. 5 out of 10 trades directly go to the stop loss, but your other 5 trades on average, first go above a 1:8 ratio, then suddenly drop downwards to end up with a loss. In the end, you have 10 out of 10 trades who lost.
Is that a good approach?
The risk reward ratio is only one part of the game. The other one is the win rate. If your risk-reward ratio is too unrealistic, you will likely never make a winning trade. So it’s even more important to find and choose the best risk reward ratio based on the underlying securities you trade.
1:1 Risk Reward Ratio
The 1:1 risk reward ratio is not that popular because it goes directly against everything you can read about it. The argument is, statistically, your probability of having a profitable day trade is 50:50. So if you win 50% of the time and make the same amount of money with every trade that wins and loses, you don’t make money.
1:2 Risk Reward Ratio
The 1:2 risk reward ratio is a frequently used ratio. The idea behind it is that if you win 50% of your trades and every winning trade makes double the money compared to what a losing trade loses, you are well in profit. But the question you have to ask yourself is, can you really archive a win rate of 50:50 if you always want to make double the money per trade than what you are willing to lose? Is that statistically a reasonable expectation?
1:3 and Higher Risk Reward Ratios
You already understand how I approach the RRR methodology, but, of course, you can drive things nuts. You can surely use a 1:3 risk reward ratio or even a 1:100 risk reward ratio. However, the winning rate you need to make this profitable is an important thing to consider.
Best Risk Reward Ratio in Day Trading
To me, the best risk reward ratio in day trading uses the 1:1 RRR and combines it with a trail-stop method, which kind of reverse-engineers the idea of using a high risk reward ratio such as 1:3 or 1:5 etc.
What that means is that at the beginning of the day trade, the risk reward ratio is set at 1:1. That’s the initial risk reward ratio (the distance between entry and stop loss equals the distance between entry and profit target.)
But once the trade is active, the stop loss level gets quickly trailed much closer to the current price level. This way, it is extremely unlikely that the initial stop loss will get triggered, but at the same time, the profit target remains at reasonable levels.
As you know, day trading is about volatility and high momentum. In most cases, it goes this way, a day trade quickly goes into profits, or if it stalls at a breakout level, it often reverses. So using a reasonable 1:1 initial risk reward ratio in combination with a quick trail stop can provide day traders with a much better outcome than always aiming for a home run with a 1:10 initial risk reward ratio.
The risk reward ratio in day trading is only one part since the win rate can make every risk reward ratio make or break. Statistically, 50% of your trades will be winners, and 50% will be losers. But if you use the best day trading strategies, quickly trail your stops and never fall into trading psychology-based traps, you are likely to make money day trading.
Becoming a day trader is challenging, and understanding the key concepts of risk reward ratios, the win rate and managing risk in general when day trading is important.
Remember, if you use risk reward ratios, you have to obey them. It is useless to define a ratio or use a specific risk reward ratio during backtesting if, during live trading, you jump from one ratio to the other. Therefore it is an integral part of implementing the exact parameters in your trading plan and trading based on that plan.