The profit-to-risk ratio is controversial and frequently discussed by traders. Some claim it is useless, while others consider it as St. Grail of trading. It may not help alone, but in combination with other metrics, it becomes a very powerful tool in the hands of the trader.
What is the profit-to-risk ratio and how to calculate it?
The profit-to-risk ratio is a measure of the distance between the stop loss level to the entry level, and the entry level to the place of profit realization, and the comparison of the distance between the two. If you know the P:R ratio, you can count the required rate of profitable trades and see if it is high enough for your historic rate, which will help you to decide whether to effect a transaction or not.
The following pattern is used to calculate the ratio:
Minimum rate of profitable trades = 1/(1+P:R)
Required P:R ratio = (1/Rate of profitable trades)-1
If you are in a position with a 1:1 P:R ratio, your rate should be more than 50%: 1/(1+1) = 0.5 = 50%
If the historical rate is 60%, you need a P:R ratio of 0.6:1 to sustain it in the long run: (1/0.6)-1=0.7
Traders who are aware of the importance of the above combination know that they do not need a high rate of profitable trades or an astounding profit-to-risk ratio to earn money.