Reward To Risk Ratio Is Not Everything In Binary Trading

In Blog by Michael Arnold

RiskOne of the most important aspects of trading in general is the reward to risk ratio (R:R), but taken alone, it has very little value. The reward to risk ratio, stated simply, is the amount a trader expects to make versus the amount they risked. So if a trader places a $50 trade and they expect a reward of $100, then the R:R ratio is 2:1. It is a more responsible metric in binary trading than “return on investment” which you see quite often, given the “$0 or $100” structure of binary options.

For example, if you open a Nadex binary option order ticket and enter 1 contract on the buy side and see “maximum risk” of $47 and “maximum reward” of $53 at the bottom, you have an approximate R:R of 1.1277:1, rounded up (53/47=1.1276595). If the reverse is true, meaning you have a max risk or $53 and a max reward of $47 the your approximate R:R is .8868:1 (47/53=.88679277), which is negative. So what does all this mean? Is a negative R:R always bad?

Well, some would have you believe yes, but that isn’t necessarily the case. A trader’s ability to succeed can only be measured by LONG-TERM profit potential. If Trader 1 has an average loss of $200 but an average of gain of $400, that adds up to a 2:1 R:R. But if this trader’s winning percentage is only 30%, then theoretically, for or every 10 trades the trader gains $1200, but losses $1400 resulting in a net loss of $200.

Flip that same example upside down and Trader 2 has an average loss of $400 and an average gain of $200 for a frowned upon .5:1 R:R, but if Trader 2 wins 70% of the time, then that same set of 10 theoretical trades results in a $200 net gain (7 wins x $200-3 losses x $400=$1400-$1200 or +$200).

Nadex binary options and Nadex spreads calculate the R:R right on your order ticket before you place the order, so it is easy to match up your desired R:R with your historical or expected win percentage. Just make sure you use both, or your trade plan will be incomplete.

Futures, options and swaps trading involve risk and may not be appropriate for all investors. Past performance is not necessarily indicative of future results