Risk and reward
What the ratio does to the hit rate you need
The page shows one set of ten trades at a 1:2 ratio and another at 1:1. What it leaves out is the general rule those two results come from. Break-even before costs happens when your wins and losses cancel out. If you win W trades and lose L trades, and the average win is R times the average loss, then W × R must equal L. With ten trades, L is 10 − W, so W × R = 10 − W. Rearranged, W = 10 ÷ (R + 1). That is the number of wins you need out of ten just to stand still.
Put numbers into that formula. At 1:2, R is 2, so W = 10 ÷ 3 = 3.33. You need more than three wins out of ten, which means four wins is the first whole number that clears break-even. At 1:1, R is 1, so W = 10 ÷ 2 = 5. Five wins out of ten breaks even. At 1:3, R is 3, so W = 10 ÷ 4 = 2.5, and three wins out of ten clear it. The ratio sets the bar, and the bar moves in whole trades, because you cannot win a third of a trade.
This is why a lower hit rate is not automatically a problem. A method that wins four times out of ten needs a ratio above 1:2 to make money before costs. A method that wins seven times out of ten can make money at 1:1, because seven wins against three losses gives 7 × 20 pips = 140 pips against 3 × 20 pips = 60 pips, a net of 80 pips. Neither method is better in the abstract. Each one has a minimum ratio it must reach, and that minimum is fixed by the arithmetic, not by how the trades feel.
Why the ratio you can get is not fixed
The arithmetic is fixed. The ratio you can actually get on a live USD/ZAR trade is not. The stop distance is a choice you make before entry, but the target distance depends on where price is willing to go. If the chart shows the next area where sellers have stepped in 25 pips away, a 40-pip target is a guess about price passing through that area. You can set the target at 40 pips, but you cannot make price reach it. The ratio on the plan is not the ratio you will collect.
Spread and slippage change the ratio in one direction. On USD/ZAR, a spread of a few pips is paid on entry and again on exit. If your stop is 20 pips away and your spread cost is 3 pips, your real loss is about 23 pips. If your target is 40 pips away, your real gain is about 37 pips. The ratio on the ticket says 1:2. The ratio after costs is closer to 37 ÷ 23, or about 1:1.6. That smaller ratio raises the hit rate you need. At 1:1.6, W = 10 ÷ 2.6 = 3.85, so four wins out of ten is now only marginally above break-even.
Swap adds a cost that depends on how long you hold. If you keep a USD/ZAR position open overnight, your broker may charge or pay a swap based on the interest rate difference between the two currencies. That amount varies between brokers and changes over time. It is not part of the ratio you set, but it is part of the result. A trade held for three days can carry a cost that a trade held for three hours does not. The ratio you plan is the starting point, not the finish.
How to compare two setups without fooling yourself
You can compare two possible trades by working out the minimum win rate each one needs. Take the stop distance in pips, add the round-trip cost in pips, and that is your real loss per trade. Take the target distance in pips, subtract the same cost, and that is your real gain per trade. Divide the real gain by the real loss to get the effective ratio. Then use W = 10 ÷ (R + 1) to see how many wins out of ten you need. If the answer is a number you have not seen in your own records, the setup is asking for more than you have shown.
The comparison only works if both setups are measured the same way. A 20-pip stop on USD/ZAR at 18.4100 is not the same rand amount as a 20-pip stop on a different instrument or a different lot size. At 0.10 lots, one pip is about R1.00, so a 20-pip stop is about R20.00. At 0.20 lots, the same 20-pip stop is about R40.00. The ratio is unchanged, but the money at risk is doubled. Compare ratios to compare methods. Compare rand amounts to compare what a loss does to your account.
One more thing the page leaves out is that the ratio is a property of the plan, not of the outcome. A trade that reaches its target had a 1:2 plan. A trade that hits its stop had the same 1:2 plan. You cannot judge the plan by one result. You judge it by whether the ratio, after costs, still clears the hit rate your records show. If it does not, the fix is to change the plan before entry, not to move the stop after entry.
1:2 ratio with 4 wins out of 10
| Step | Amount | Note |
|---|---|---|
| Stop distance | 20 pips | the distance from entry to stop, chosen before the trade |
| Target distance | 40 pips | twice the stop distance, so the ratio is 1:2 |
| Position size | 0.10 lots | a standard lot is 100,000 units; 0.10 lots is 10,000 units |
| Value of one pip | R1.00 | for 0.10 lots on USD/ZAR at about 18.4100, one pip is about R1.00; this varies with the rate |
| Loss on one losing trade | R20.00 | 20 pips × R1.00 per pip |
| Gain on one winning trade | R40.00 | 40 pips × R1.00 per pip |
| Six losing trades | −R120.00 | 6 × R20.00 |
| Four winning trades | +R160.00 | 4 × R40.00 |
| Net result before costs | +R40.00 | R160.00 − R120.00 |
Your broker may round pip values, charge a spread, commission or swap, and quote a different USD/ZAR rate. Those costs reduce the net figure, and they vary between brokers.
Doing it once, step by step
These steps take you through the arithmetic once, using the same USD/ZAR figures as the page, so you can repeat it on your own numbers. Work through them in order.
- 01
Write down the stop and target in pips
Choose a stop distance and a target distance before you look at any rand value. For example, 20 pips stop and 40 pips target. Write them down. Do not change them after this point.
- 02
Add the round-trip cost to the stop
Ask your broker what the spread is on USD/ZAR at the time you would trade, and whether commission applies. Add that cost to the stop distance. If the spread is 3 pips, a 20-pip stop becomes a 23-pip real loss.
- 03
Subtract the same cost from the target
Take the target distance and subtract the round-trip cost. A 40-pip target becomes a 37-pip real gain. Use the same cost figure for both sides, because you pay it on entry and exit either way.
- 04
Divide the real gain by the real loss
Divide 37 by 23 to get the effective ratio, which is about 1.6. Write that number down. It is the ratio after costs, not the ratio on the ticket.
- 05
Work out the wins you need out of ten
Use W = 10 ÷ (R + 1). With R at 1.6, W = 10 ÷ 2.6 = 3.85. That means four wins out of ten is the first whole number above break-even. If your records show fewer than four, the setup does not clear its own costs.
- 06
Compare that number with your own record
Look at your last fifty trades and count how many reached the target. If the count is below the number you just worked out, the plan needs a wider target or a tighter stop before entry. Do not widen the stop after entry to avoid a loss.
The mistake most people make here
The common mistake is to move the stop further away when price comes close to it, while leaving the target where it was. That changes the ratio after the trade is open, and it turns a planned R20.00 loss into something larger. The arithmetic only works if the stop and target are set before entry and left alone. If the reason for the trade has gone, close it at the stop you chose, not at a new one.Check yourself
With a 1:2 ratio, 20 pips stop and 40 pips target on 0.10 lots, what is the net result over 10 trades if 4 win and 6 lose, before costs?
Wins: 4 × 40 pips = 160 pips. Losses: 6 × 20 pips = 120 pips. Net: 160 − 120 = 40 pips. At about R1.00 per pip, that is +R40.00 before costs.
If the same 10 trades had a 1:1 ratio, with 20 pips stop and 20 pips target, what would the net be with 4 wins and 6 losses?
Wins: 4 × 20 pips = 80 pips. Losses: 6 × 20 pips = 120 pips. Net: 80 − 120 = −40 pips, or about −R40.00 before costs.
Questions that come up next
If I need four wins out of ten at 1:2, what happens if I only get three?
At 1:2, break-even needs more than three wins out of ten. Three wins give 3 × 40 pips = 120 pips. Seven losses give 7 × 20 pips = 140 pips. The net is 120 − 140 = −20 pips, or about −R20.00 before costs. Three wins is a losing series at that ratio, even though the wins are twice the size of the losses.
Does a higher ratio always mean I need fewer wins?
Yes, on the arithmetic. The formula W = 10 ÷ (R + 1) shows that a larger R gives a smaller W. At 1:3 you need three wins out of ten. At 1:4 you need W = 10 ÷ 5 = 2, so two wins out of ten clears break-even. But a higher ratio usually means a target further away, which price reaches less often. The arithmetic is fixed; the ratio you can get is not.
How do I work out the ratio I am actually getting after costs?
Take the pips you keep, not the pips on the ticket. If your stop is 20 pips and your round-trip spread cost is 3 pips, your real loss is about 23 pips. If your target is 40 pips, your real gain is about 37 pips. Divide 37 by 23 to get about 1.6, so the real ratio is about 1:1.6. Use that figure in the formula, not the one you planned.
What is a pip worth on USD/ZAR at 0.10 lots?
At about R1.00 per pip on 0.10 lots, a 20-pip stop is about R20.00 and a 40-pip target is about R40.00. That is the figure used throughout this lesson. The exact value depends on the USD/ZAR rate at the time, which moves. Your broker may also round pip values, so check the contract specification.
Can I change the ratio after the trade is open?
You can change the stop or the target, but that changes the ratio you are trading. Moving the stop further away while leaving the target where it was turns a planned R20.00 loss into something larger. The arithmetic in this lesson assumes the stop and target were set before entry and left alone. If the reason for the trade has gone, close it at the stop you chose.
Does the FSCA set the ratio I have to use?
No. The FSCA regulates firms that offer these products in South Africa, but it does not set risk-to-reward ratios. The ratio is a choice you make on each trade. What the regulator does require varies by firm and by product, and the rules can change. Check the current position with the firm you use.
The words used on this page
- risk-to-reward ratio
- The size of your planned loss compared with your planned gain on one trade. A 1:2 ratio means the target is twice as far away as the stop. It decides how many wins you need out of ten just to stand still.
- hit rate
- The share of your trades that win. Four wins out of ten is a hit rate of 40 per cent. The ratio you use sets the minimum hit rate you need before costs.
- break-even
- The point where your wins and losses cancel out, before costs. At 1:2 with ten trades, break-even sits between three and four wins. Four wins is the first whole number that clears it.
- spread
- The gap between the price you can buy at and the price you can sell at. You pay it on entry and again on exit, so it reduces both your wins and your losses. A few pips of spread can turn a planned 1:2 into something closer to 1:1.6.
- slippage
- The difference between the price you expected and the price you actually got. It often appears when price moves quickly, and it can make a stop loss larger than planned. Like spread, it varies between brokers and between moments.
- stop
- The price at which you close a losing trade to cap the loss. It is set before entry. Moving it further away after entry changes the ratio and can turn a planned R20.00 loss into a larger one.
What to take away
- The ratio sets the hit rate you need: at 1:2 you need more than three wins out of ten, at 1:1 you need five.
- The arithmetic is fixed, but the ratio you can actually get is not, because price decides how far the target is reached.
- Spread and slippage shrink your real ratio, so use the pips you keep, not the pips on the ticket.
- Set the stop and target before entry and leave them alone, or the arithmetic no longer describes your trade.