Stop Loss and Take Profit are key components of an effective risk management strategy and striking the right balance can have a significant impact on your trading success. But, before we get started, let’s take a closer look at what they are:
As discussed in one of our previous blogs, Stop Loss is an order that instructs the broker to sell automatically when a trade drops to a certain price. The purpose of a Stop Loss Order is to limit the losses you make on any given trade, therefore reducing your risk.
Take Profit works in much the same way, by instructing your broker to sell when a trade reaches a target price. Also a risk management tool, the purpose of this is to lock in your profits before they drop.
What Ratio Should I Use?
There’s no straightforward answer to what ratio anyone should use as it depends on many factors including market conditions, your trading style, and risk tolerance.
- If the market is volatile, then a wider ratio may be more beneficial. This would help to prevent an early exit from a trade that could end up being potentially profitable. In a more stable market, tighter ratios may be more beneficial. Orders should be monitored and adjusted as market conditions change.
- Your trading style might affect how you choose to set your Stop Loss and Take Profit. A day trader may choose tighter ratios to make quick profits, whereas swing traders may choose a wider ratio to benefit from larger market movements.
- Consider what your risk tolerance is on each trade, finding a level that you are comfortable with.
Popular ratios can range from 1:1 to 3:1 reward-risk, however, one of the most common ratios is 2:1. This means that for every dollar (for example) you are willing to risk, you are targeting a 2-dollar profit.
- Using a 1:1 ratio can help you manage risk effectively, as it balances potential loss and gain, avoiding risk while protecting capital. However, it could result in trades closing too frequently, limiting the potential for larger profits. You would need to have a winning trade 50% of the time to break even.
- A 2:1 ratio is the most commonly used as it allows for greater potential profit, compared to the risk you are taking. However, it does require a higher win rate to offset losing trades effectively.
- Using a 3:1 ratio gives the biggest potential for larger profits, compared to the amount of risk. However, using this high reward-risk ratio requires traders to be disciplined and accurate so that they can maintain a high win rate. If they don’t, then traders may end up with losses rather than profits.
When choosing your reward-risk ratio, what matters is that your overall profits exceed your overall losses. Another point to consider is that rather than looking at ratios as a stand-alone thing, it needs to be looked at along with your win rate. The higher your reward-risk, the lower win rate you will need to break even or make a profit. A trader with a 3:1 reward-risk only needs to win ¼ trades to break even. Whereas a trader with a 1:1 ratio needs to win ½ trades to break even.
In conclusion, a higher reward-risk ratio is often preferred as it offers more potential for a bigger ROI without taking too much risk. Having said that, going too high on your ratio may signal that a trade is excessively risky. Combine your win rate, risk tolerance and trading style with analysis of the markets and you will find a ratio that works for you.