Some mechanical systems that I’ve designed have been optimised using small R:R ratios like 0.25-to-1 or 0.5-to-1 reward-to-risk. This flies in the face of most material that you read over the internet or in books, which typically recommend 2-to-1 or over. Does anyone trade with small R:R ratios? Care to share your experience? What are people’s reasons not to trade with small R:R?
The biggest weakness to small R:R ratios is its sensitivity to losses, IMO. With 0.25:1 reward:risk, I will need to win four trades just to breakeven after one loss. However, if my backtests show that I have 8 wins for every loss, then clearly I will make profit over the long term and should trade with this ratio (assuming it provides a bigger profit factor than all other R:R ratios).
I generally draw the line at 0.25:1 reward:risk. Below that, I do believe a system becomes too sensitive and vulnerable to ahistorical trading conditions.
To me, I see R:R ratios below 1 as the inverse of R:R ratios above 1, and should be treated as such. For example, a 0.5:1 reward:risk ratio is the inverse of 2:1 reward:risk, and should be seen like 2:1 reward:risk. Both ratios are equally sensitive to changes in win and lose rates (except that both values have been reversed, obviously).
with a 2:1 risk:reward ratio you need to win at least 66.6666% of the time to break even
so if you have higher win rate than that, that’s certainly doable
i believe a lot of scalpers use higher risk than reward ratio since spreads are a factor
they only pick up a few pips each trade but at the cost of 10-30 pips lost
While my risk reward tends to be slightly better than yours, I think it’s perfectly acceptable to have a small R:R if your win rate is high.
IMO when people talk about using good R:R, they mean it for trade setups that have a good but not great win rate. It’s also more for discretionary traders than it is for mechanical traders. If your system is specific to certain patterns in price or indicators and back tests give you profits with low or losing R:R, go for it.
Remember, at the end of the day the only thing that matters is being profitable. If low R:R hasn’t killed your account after a good number of trades, then you’re doing something right, and you should keep doing it
If you have an exit that is independent of the entry, and not defined at entry (like I use) then you can only calculate R:R after the trade is closed, and so profitability is the only measure of the system long term.