Each Trade’s Risk to Reward
By Bennett McDowell, TradersCoach.com*
Posted: Feb 3, 2006

The explanation of the concept of “Risk to Reward” in trading goes something like this: Before you take a trade, the reward must be a certain percentage better than the risk. This percentage is usually represented as a ratio. I am going to make a case for why this type of analysis is flawed, and the traders who use it are kidding themselves.

So that I can show you how absurd this concept of risk to reward is, let’s start with an analogy. Let’s say that if, before you get out of bed each morning, you ask yourself, “What is my risk of reward or chances of success today if I get out of bed?” If your answer is “Poor”, you stay in bed; if it’s “Good”, you get out of bed and start your day.

Now compare this to trading. Let’s say, before you decide on a trade, you say to yourself, “What is my risk of reward today or chances of this trade being successful?” If the answer is “Poor”, you do not take the trade; if, on the other hand, it is “Good”, you take the trade.

The problem with this thinking is that you may never get out of bed (or, in our trading example, take a trade)! Because the analysis is dependent on how you see the world and how you perform your analysis (which, in both examples, is subjective), it is flawed from the start!

We really do not know which day or trade will be good, so traders who use this risk-to-reward approach are fooling themselves because we really cannot predict future price movement. In fact, you will find that most traders who calculate the risk to reward for each trade are right about 50 percent of the time, which is the same as a coin toss.

But, traders use this concept of risk to reward because it makes them feel in control of the risk inherent in trading. And, most traders need to feel they control the risk in trading. But, I will let you in on a secret: No one controls the risk inherent in trading!

What I want you to think about is trading the realities of the market, flowing with markets and accepting the inherent risk in trading, so you can profit. Basing trade entries and exits on the realities of the market and then applying strict risk control methods that determine your “Trade Size” for each trade is the way to embrace the risk in trading instead of denying it as so many trading approaches seem to do.

Any time you try to predict future price movement based on your judgment and interpretation of market dynamics, you are really just guessing!  

Compare this with trading the realities of the market and basing trade decisions on market realities so that you are trading with the market and not forming opinions about market direction or having to interpret market news or mathematical logarithms. 

We have to get out of bed each day and face the realities of the world we live in. Think about how absurd it would be to base your decision of whether to get out of bed each day on a concept that asks you to guess whether the day will be good or not. Is that any way to live your live your life? NO!!!

The reality is that we just don’t know what each day will bring, but we do know that, to get what we want from life, we need to get out of bed and try our best based on the realities of the day. We can take risks based on known parameters and not on unknown or “un-grounded” assessments of what may happen today.

So, if you are using the concept “risk to reward” in your trading, think about all the profitable trades you missed because market dynamics did not go according to your guess. You may want to rethink this very popular concept that lures many traders into the illusion of security.

*Reprinted (and modified) with permission from Bennett McDowell