Trading Risk to Reward
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This article includes:
- Using a risk-to-reward ratio (RR) on a chart.
- Using the ideal RR; not too big, not too small.
- How to apply averaging strategies, like Martingale and DCA, to cryptocurrency trading.
In my previous articles we looked at risk management and risk-to-reward, including a discussion of Martingale and DCA strategies. Now we have to apply this knowledge to trading charts and calculate the risk-to-reward ratio of each trade.
By now you know you want the lowest risk and the highest reward. Finding those trades is the joy of trading. Where can I place $100 to make $1000 almost 50% of the time? That is always the question. The answer is found, of course, after doing a bunch of research on trading methods and strategies to identify the right trades. I’ll discuss more about methods and strategies in later articles, so for now we will chart some risk to reward scenarios to get used to the RR charting tool.
How to use a risk-to-reward ratio (RR) on a chart
The screenshot below shows the long position RR charting tool in Trading View (featured in a previous article).
When you place it on a chart, it will look like this.
The top green box is potential profit, or how much money you could gain. It shows that your target is 10 points above, or 10.16% in this case. The middle, where the green and the red box touch, is your entry point. This shows that if you entered here, you could make a potential 10% profit (based on the top green box). The red box shows you how deep your stop is, or how much money you could lose. Combine both and you are able to calculate the risk-to-reward ratio. In this case, it is 1.55. If you start with $100, your reward is gaining $10 (for an end total of $110, or +10%), but you are also risking losing $6.5 (for an end total of $93.5, or -6.5%).
Looking at the numbers, a RR of 1.55 doesn’t seem worth it — risking $6.5 to make $10. When you look at where 1.55 lines up on this graph, you would need to be right about the trade more than 45% of the time (the win rate).
Until you get more experienced and can use a method that gives you a better win rate than 45%, you’ll want to stay with a RR that’s above 2. The higher the risk-to-reward ratio, the less you have to be right in trading. Less risk and more reward is the best strategy. Let’s look at an example in a real chart.
https://www.tradingview.com/x/tRkkoeyg/
You can ignore the yellow horizontal lines (I will talk more about them in a later article). For now, I have identified an entry, an exit, and a stop loss. I have adjusted the boxes to match my lines and the tool shows a risk-to-reward ratio of 6. The top and bottom boxes show that my prospective trade has the potential to make 19%, and the potential to lose 3%. So if I start with $100, I will either make $19, or lose $3. Doesn’t this sound more appealing than making $10 or losing $6.50? And if I reference the chart, I know that I only need to be right about 15% of the time (or 1 time in 6) since the RR is 6. One win will make up for six losses (roughly).
Let’s look at that trade after it completed.
https://www.tradingview.com/x/yWlFAw5V/
Many will say that it’s easy to show a win after it happens, but what about going forward? You have to find a strategy that works for you, where what has already happened can help you figure out what will happen in the future. Remember, it’s like predicting the weather. The more you learn about meteorology, the more accurate your forecast will be, but no forecast is ever guaranteed. Trading is like the weather; if we are wrong, we have to accept it. That’s why we have stop losses; they’re like having an umbrella handy when you didn’t expect it to rain.
Looking more carefully at the chart above, you can see that the price spiked down and came close to the stop loss (the small segment at the beginning in red). However, it didn’t hit it, so the trade continued and went up, completing at the line. My forecast worked out, and I didn’t lose any money.
Keep in mind that this is based on both your capital and your time frame. Trading doesn’t need to involve just $100, like the examples I am showing. You might have $100,000, risking $3,000 to make $19,000. This was also in a day time frame, but you might want to look at shorter or longer time frames. This is why trading cryptocurrencies is exciting and worth it in my opinion.
The ideal risk-to-reward ratio: not too big, not too small
What if I had a tight (a.k.a., small) stop loss in an attempt to strictly limit my risk? This introduces a different risk: you might get stopped out. Let’s replay the example above with a tighter stop.
https://www.tradingview.com/x/kln7GnoE/
A risk to reward of 17? That would be amazing; you would only need to win 1 in 17 to break even. Unfortunately, you need to be realistic; the stop loss in the example is set at 1.1%, and a 1% dip from entry is likely. If you’re going to set a tight stop loss, your win percentage on a 1% dip to your stop loss has to be on point, or you will get stopped out. Worse, you get stopped out, and then the trade hits your target when you’re already out of it.
https://www.tradingview.com/x/6fMBxaqQ/
You’ve only lost a small amount, but it’s a real kick in the teeth to realize that if your stop loss was a touch more generous, you could have gained a lot more.
The following table (similar to the line graph far above) shows each risk-to-reward ratio and the minimum percentage of times that you need to be right in order to take that trade.
As with so many things in life, moderation is key. Anything over a RR of 10 should probably be reconsidered because your target and stop loss start getting unrealistic. There are such things as high risk to reward scenarios, but note that the higher they are, the more unrealistic they are.
Conversely, the lower the risk-to-reward ratio, the less likely the trade is worth it. Why would anyone want to take a 1 to 10 trade (0.1 RR)? They would have to be 91% accurate to make it. A RR below 1 is bad — never take it. Around 1 works for very experienced traders. I aim for a risk-to-reward ratio between 2–9, but always a minimum of 2.
How do averaging strategies (like Martingale and DCA) apply to these risk-to-reward scenarios?
To use either the Martingale or DCA strategies, you’ll want to stagger orders around the entry zone you have identified. This modifies the size of the trade based on your capital, but allows you to manipulate your RR and win percentage. I’ll use the same trade example I used above and apply the Martingale strategy.
https://www.tradingview.com/x/tRkkoeyg/
I’ll stagger orders starting at the entry line all the way down to the stop loss line.
On the chart it looks like equal spacing on these values, but on the exchange I have these orders placed as follows. (Total capital is $1400 in this example.)
Buy Orders
105.04 — $200 (this is my initial “bet”)
103.94 — $400 (when the trade loses once, I double down)
102.83 — $800 (when the trade loses twice, I double down again)
Stop Loss
101.50 — sell all (I cut my losses and leave the trade)
Now I want to calculate the weighted average entry point so that I can calculate the RR.
(200×105.40) + (400×103.94) + (800×102.83)
— — — — — — — — — — — — — — — — — — — — — = 103.51
(200 + 400 + 800)
103.51 is my averaged entry for $1400. If I double-click the risk-to-reward chart tool and adjust the entry price to my averaged entry, I’ll see what the Martingale risk-to-reward ratio is once I get back to the chart.
The charting tool has now adjusted the RR calculation to 10.41.
https://www.tradingview.com/x/KGsAvF1w/
With a modified RR of 10.41 instead of the original 6, the trade now has much better odds, and as a bonus you can see that the trade has started going back up. This is how you turn the odds in your favor, making entries and risk-to-reward ratios more juicy and favorable.
This is how you trade “safely,” consistently staying alive and scaling in and out of your trades. I risked less, yet used more capital by staggering my entries, which can be done either by dollar cost averaging or doubling down every time with Martingale. You can apply the same strategies to selling. Instead of an all-in order, you could slowly sell on the way up, essentially Martingale-ing out of your position to bring your weighted sell average as high as you can, while having your weighted buy average as low as you can.
There are hundreds of trading opportunities like this every day. There is no way to take advantage of every single one (that’s a lot to manage!), so start by focusing on one coin pair, or a few of the top cryptocurrency coins (according to market cap). I have used the Martingale method in a proof-of-concept fashion as well as tried it on real trades for 4 months. It has had a 100% win rate, depending on the amount of risk and the exit strategy. One idea that should be attached to a Martingale strategy is “if we get to this buy zone, get out at next possible profit.”
Let’s say you have 10 buy orders and you place an all-sell order at a certain percentage of profit (even just 1% above where you started). This happens on your 7th trade, so having made your profit, the remaining 3 trades are abandoned and the sell order goes through. Then you can simply restart, placing another block of 10 buy orders. This strategy could actually be one of the reasons why markets have relief waves, which you can see when removing candles and just following the price in a wave format.
https://www.tradingview.com/x/87kE950R/
This is like the waves-inside-waves I discussed in a previous article.
Or in this example.
https://www.tradingview.com/x/q8kPTTHE/
In my opinion, this is how DCA and Martingale methods are meant to be used. Many people don’t even look at a chart and follow a DCA strategy by buying every day, and that is fine as well. Your method is your method — do what works. Do whatever is stress-free. We are all in this together.
Takeaways
In this article we looked at applying the concept of risk-to-reward to cryptocurrency trading, and how using averaging strategies in a trade can affect your risk to reward.
- On a chart, the risk-to-reward ratio is calculated based on your entry point, your goal, and your stop loss..
- The ideal risk-to-reward ratio is neither too high (unrealistic) nor too low (not worth it). Aim for an RR of 2–9.
- An example of how to use the Martingale strategy to skew the odds in your favour.
