Risk-Reward Ratio Determination

Trading the futures markets is all about balancing risk, and the threats posed by trading in leveraged instruments, with the potential rewards from successful trading. Generally, you should be seeking opportunities where the potential rewards outstrip the risks you face, and you should be able to determine at a glance whether a trading opportunity represents this kind of attractive proposition. As you trade your way through the markets, you will notice that the complexity of the numbers involved in your trading becomes more and more of an issue, and so identifying risks and rewards and deciding on whether a trade is worth it on the fly isn’t always particularly straightforward.

As a result, many traders think of the risk vs. reward profile of a particular transaction as a ratio of expected upside gains to the allocated maximum financial risk of a particular trade, which helps break down a proposition into basic, manageable numbers. This enables more coherent, consistent decision-making and helps identify the best trading opportunities you are presented with. So how is the risk to reward ratio determined, and how can you start calculating risk: reward in your trading?

The Formula and Examples

As we’ve briefly mentioned, the formula for calculating risk to reward is mathematical, and will produce definitive numerical results. It’s important to understand that this bears no relation to the chance of failure – the ratio only calculates the size of potential downsides in comparison to upsides. So, it might be the case that there is a low risk to reward ratio where the risk is much more probably an outcome than the reward, even though the reward portion may be comparatively larger. It’s important to realise that while the risk-reward ratio is a vital, indispensible tool, it doesn’t reflect the whole picture and shouldn’t replace your personal common-sense filter.

The formula for calculating the risk-reward ratio can be expressed as Anticipated Profits: Anticipated Losses. In practice, the risk-reward ratio is only useful if it is taken to a common denominator – in other words, you need to then divide AP by AL to calculate the numerator figure. Here are a couple of worked examples.

Example 1

Futures on Company X shares are trending upwards. You buy at £10 per futures contract and anticipate the value will rise to £15. At the same time, you set a stop loss at £5, as the floor level at which you are willing to risk your position. The risk to reward ratio is calculated as follows

Anticipated profits: anticipated losses
1:1 ratio

Example 2

Futures on soya are trading at £12, and you anticipate a rise to £20 over the lifetime of your trade. You set a maximum loss of £10 on your futures. The risk to reward ratio is calculated as below

Anticipated profits: anticipated losses
4:1 ratio

The Benefits

The benefits of calculating and using the risk to reward ratio, while not absolute, are many and varied. Firstly, using the ratio enables you to identify at a glance whether a trade is an efficient way to deploy your capital. If the ratio is greater elsewhere, indicating a greater reward to risk, you will know that it perhaps represents a more advisable choice for your capital. When capital is your only asset, as with futures trading, making the most of it is crucial towards ensuring you maximise your earnings potential, and this is one way of achieving this end. Similarly, the risk reward ratio highlights instantly whether a proposition is too risky – something that isn’t always apparent from studying the numbers in abstract.

Additionally, having a ratio worked out to a common factor (i.e. x:1) allows you to compare different trades and transactions ahead of time. While the numbers involved might not lend themselves particularly to easy comparisons, using the ratio makes comparing like for like easy – crucial in allowing you to trade to your fullest potential.

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