Is a Reward to Risk Ratio Inherently Better Than Another?

Reward, Risk, Ratio, Inherently, Better Than, Another, Trading Systems, Fx trader, forex

When designing trading strategies new traders are usually advised to create systems where the average winning trade is significantly larger than the average losing trade. Systems where the reward to risk ratio is higher are said to be easier to trade since they require lower winning ratios to be profitable, therefore exerting less psychological pressure on any individual trade. However people who use low reward to risk strategies generally argue that the reward to risk chosen is irrelevant since what matters in the end is not the size of the average profitable or losing trade but the actual expectancy of the trading system – the product of the winning ratio and the reward to risk ratio.

We can better understand how reward to risk ratios affect trading by exploring the result of various reward to risk choices under random trading scenarios. If the reward to risk ratio really does not matter then the outcome of trading based on random entries should be the same regardless of whether we trade at a 1 to 1, 1 to 2 or 2 to 1 reward to risk ratio. If the size of the average winner and the average loser is compensated in every case by the winning ratio we shouldn’t observe significant differences in terms of the mean return of the different experiments, as the expectancy in any case should be identical (a slightly negative expectancy due to the spread).

In order to assess the above 3 different experiments were carried out on each symbol (EUR/USD, GBP/USD and the USD/JPY) using 1H data from 1986 to 2016. In each experiment the risk to reward ratio was chosen to be either 1:1, 1:2 or 2:1 expressed as a stop-loss and take-profit on each trade with values of 100% or 50% of the 20 period Average True Range (ATR-20) indicator calculated on the daily timeframe. In every case the risk was kept at 100 USD per trade when the stop-loss was hit. Whenever there were no trades open the system would enter a long trade, enter a short trade or stay on the sidelines with an equal probability. Each experiment was composed of 2550 simulations. A constant spread of 3 pips per trade was used throughout all the experiments.

Reward, Risk, Ratio, Inherently, Better Than, Another, Trading Systems, Fx trader, forex Figure1

Figure 1: EUR/USD results - Yellow 1:1 plot, Green 2:1 plot, Red 1:2 plot