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Risk Reward Ratio in Trading

RR>3 stands for Risk Reward greater than 3.

What is Risk Reward Ratio?

Risk Reward Ratio is defined as the ratio of potential reward (target) in percentage divided by the potential risk (stop loss) in percentage for any trade set up.

Suppose you are entering a stock at Rs. 100

Your target is Rs. 115 or 15%

Yout stoploss is Rs. 95 or 5%

Then you Risk Reward Ratio is 15%/5%= 3

When you determine you are ready to go 'long on a stock' (buy a stock) you need to determine your stop loss and target level before you make the entry, that is, before you buy the stock.

text image showing risk reward is ratio of target % to stoploss %
formula of risk reward ratio

In the world of trading success often boils down to a simple yet profound formula.

After nearly 12 years of making mistakes and introspecting to make improvements, I have condensed my past learnings, workflow and aspirations "RR>3".

These 4 characters are more than a mere mathematical expression; Together they form a guiding principle for decision-making.

Let's now discuss how can it be the key to success in trading?

The Essence of RR>3: The Formula for Success

At its core, the RR>3 principle is straightforward: for every unit of risk taken, atleast 3x of that risk should be available as potential reward.

This approach shifts the focus from the frequency of success that is profits to the quality of opportunities picked.

Why RR>3 Matters

  1. Balancing Probability and Payoff: In trading not every risk taken will lead to profitable exit. However, by following the RR>3 rule, the probability of success can be skewed in our favour. RR>3 means we need 1 good trade in every 4 trades to maintain breakeven portfolio. A 25% success rate is easier to schieve than a 50% (RR=1)

  2. Cultivating Discipline: Adhering to the RR>3 ratio fosters a disciplined approach. It discourages impulsive decisions and encourages thorough analysis to identify opportunities with a high payoff potential.

  3. Risk Management: By prioritizing opportunities where the potential reward significantly outweighs the risk, you inherently manage your exposure to loss. This is crucial in trading, where risk management is the cornerstone of long-term success.

Practical Application in Trading

  1. Setting Stop Losses and Take Profits: In trading, RR>3 can be applied by setting stop-loss orders and take-profit points. For instance, if you risk $1, your take-profit should be at least $3 away from your entry point.

  2. Selective Trading: This principle encourages traders to be selective, choosing only trades that meet the RR>3 criteria. It's about quality over quantity.

Beyond Trading: Applying RR>3 in Life

The RR>3 principle isn't confined to the financial markets. It's a mindset that can be applied in various life decisions, whether it's career moves, investments, or personal growth endeavors.

  1. Career Decisions: When considering a job change or an investment in education, weigh the potential rewards against the risks. Aim for options that promises a return atleast three times the cummulative cost of effort, spend, and risk involved.

  2. Personal Relationships: Invest your time and energy in relationships that offer mutual growth and support. The rewards should outweigh the emotional and time investment by a minimum of 3x.

  3. Health and Wellness: Apply the RR>3 principle by investing in habits and lifestyle changes that offer significant health benefits in comparison to the effort or cost involved. This also means you need to start associating a cost to unhealthy eating habits and poor sleeping schedules.

Conclusion: Making RR>3 Your Reality

Embracing the RR>3 rule is about adopting a mindset where you constantly seek a high return on your investments, be they financial, emotional, or time-based. It's a strategy for not just surviving but thriving, in the unpredictable world of trading and the equally complex journey of life. By making this principle a fundamental part of your decision-making process, you set yourself on a path to success, measured not just in financial terms but in overall fulfillment and achievement.

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