Risk Reward
I use the term Risk-Reward aka RR, but the correct term is Relative-Risk (RR). Some people add the word “Ratio” at the end of both phrase and a 3rd R onto the acronym. The choice is yours for whichever term you want to use. Most people should understand what you mean when you talk about you RR. On this page, I’ll discuss how to calculate RR for binary options and everything else. I don’t talk about vanilla options, since I don’t trade them. I don’t know how the RR would work for them.
Binary Options
For binary options, it’s pretty straight forward. When you enter a trade you know exactly how much risk and reward there is. Your bet size is your risk and the reward is the percentage payout. In this sense, since everything is fixed for binary options, you can’t really tweak your RR ratio. The only thing you can aim for is to be above your break-even ratio. Examples of how to calculate this ratio is shown below. Your break-even ratio is based on the risks and the rewards of the trades that you make. Using the first line as an example. in order to break even, you must win 62.5% of your trades based on those ITM and OTM percentages.
So, in binary options, you’re just aiming to be above your break even ratio (Forex and stocks function differently). Your success ratio tells you if you’re profitable or not. This should be fairly straight forward to understand. The only thing to note is that, the break-even ratio is fixed for any number of trades. You could trade 100 trades, 1000 trades, 10,000 trades and the ratio would be the same. You need to win 62.5% of the trades for each number of trades to break even.
Basically the calculation for these are as followed:
ITM%A – OTM%B = 0 Given A + B = 1 (basic law of probability), B = 1 – A, sub back into it and solve for A
ITM%A – OTM%(1 – A) = 0
ITM%A + OTM%A = OTM%
A = OTM% / (ITM% + OTM%)
Example:
60A – 100B = 0
60A – 100(1 – A) = 0
60A + 100A = 100
A = 100 / (60 + 100) = 62.5% is the win ratio needed to break even.
ITM% is the payout percentage for getting it In The Money
OTM% is how much it costs you if you lose for getting it Out of The Money – i.e. 100% OTM = they take everything if you lose, vs 90% OTM means you get 10% back
Forex and Stocks
Unlike binary options, forex and stocks have value. In this sense, you can control the RR ratio. Having a value especially a numerical value as opposed to a percentage goal in binary options, can help you determine stop loss (SL) targets, take profit (TP) targets support, resistance etc. These help you control your enries and exits when trading. This in turn helps control your RR ratio. By knowing where all these target levels are, you can guage which trades are better to take by comparing the RR ratios. This is more of a strategy topic so I won’t get into comparison of RR ratios and all that stuff. But what I wanted to get into, is the RR ratio.
Every good trader that you talk to, will usually ask you if you have your stop losses in place. This determines how much you’re willing to lose on a trade. Different money management strategies can be implemented depending on your level of risk. Disicipline is another topic here, this helps determine how you trade. In both forex and stocks, the prices are quoted in bid/ask format. This in itself already contains a spread, which if you’re buying at the ask, you’re automatically down right away because the bid is lower than the ask. Some people just add onto this spread and include it as the SL. For example, EUR/USD on oanda at times has a spread of 2 pips, you’re SL could be 10 pips total. This actually just translates to 8 pips lower than the current bid. Versus someone else who adds 10 pips ontop of the spread, so you’re total SL would be 12 pips instead. However you choose your stop loss is up to you when you set your RR ratio.
On the other side of the equation to determine the RR ratio is to set your reward aka your target TP levels. So, for example your risk (aka SL) is 10 pips and your reward (aka TP) is 50 pips. This gives a 1:5 RR ratio, which is pretty good, you’re risking only 1/5 of what you’re potentially gaining. This would be on a good signal, if you’re scalping forex, you’re probably aiming for lower RR ratios like 1:1 or 1:2 etc. Having a controlled loss is always a good thing in trading so you control how much you lose, you don’t let your emotions get the best of you and wipe your account for no reason.
PS: Some of my FX demo trades don’t have SL’s because I don’t enter my SL upon entry into a trade, I enter it after I enter the trade. If after entering, I feel it’s a bad trade, I just exit without setting my targets.