Risk-Reward Ratio (CRV) – Evaluate Trades Correctly!

The Chance-Risk Ratio, often abbreviated to CRV, plays a central role in trading and you will surely have come across it at one point or another.

Contrary to what may seem obvious, CRV has nothing to do with the probability of success of the next trade – at least not directly – but CRV describes how your potential profit from the next trade compares to the risk taken.

Let’s take the following example: You want to buy share X at the current price of 107.04 euros. You hedge this trade with a stop loss of EUR 99.50 and the target for this trade is a price of EUR 135.00. Using these quantities, you can now determine the CRV for this trade by dividing the potential profit by the initial risk.

The potential profit (chance) derives from the difference between your target price and the purchase price:

Chance = 135.00 euros – 107.04 euros = 27.96 euros

Your initial risk is the difference between the cost price and your initial stop loss:

Risk = $107.04 – $99.50 = $7.54

By dividing these two amounts, you now get the CRV for this deal:

What does this indicator say?

With CRV, you can only see what you expect to win for every euro you risk, as long as your goal is reached. In the example above, you expect to make 3.71 euros in profit for every euro risked.

That’s all well and good, but how does that get me anywhere?

Not much in terms of the next trade, because with the CRV you have no idea if the next trade will be a winner or a loser. But the CRV is an important statement for your long-term success, because as the CRV increases, your chances of winning in the long term increase. At least that is the unanimous tenor of many publications on the subject of trade. The reason for this seems logical, because the bigger your CRV, the more often you can afford to lose.

Let’s say you only enter into contracts with a CRV of at least 3.71 in the future.

Then you could theoretically lose all risk 3.71 times in a row and would only need a profit on the next trade to get to plus-minus zero overall (fees excluded). This means you wouldn’t be a loser in the long run with a hit rate of only 22%. Against this background, it is not surprising that one often only reads trades with high CRVs, but it is only those half truth.

Correct handling of CRV

In general, it is recommended to only enter into trades where the CRV is at least 1.5 or 2, and the larger the CRV, the better a trade is said to be.

The problem, however, is that you can only estimate the chance – unlike the risk, which is already firmly defined by your fixed stop loss before the start of the trade. However, an estimate makes this metric very vulnerable because it raises the question of how realistic it really is that the stock will reach the target price? This question is DOES NOT can be answered with certainty, but is at most supported by empirical values.

Statistical studies can also be used to determine the chance as precisely as possible. If, for example, a stock has already moved up 30% from its year-to-date low, and you know from a similar analysis that the swing range within a year was rarely more than 40%, you can use the current option with a Determine a price gain of another 10 %. Key supports or resistances can also be used to determine the opportunity.

Stop dreaming!

ONE major problem still exists: Traders like to dream! Estimating the odds in a trade can quickly become a victim of mood. If you are hot to trade and/or see a new big bull market just around the corner, then you are quick to overestimate the targets unrealistically high. The same should apply to situations where you have suffered various losses over a long period of time. Again, we tend to overestimate the potential of a trade, especially in combination with the associated probabilities. If we have lost three or four times in a row, then an argument like this is not far off: Now the trend reversal must succeed. How far will the price fall?

The problem with the many resistors/supports

It quickly becomes clear that estimating CRV does not work without a certain amount of ignorance when looking at where the next resistances (supports) may be found.

If we enter a trade long, it seems likely that price could bridge the gap to the next resistance. However, we usually find the first resistance after our entry just a few cents or euros above it. You are welcome to try it once. Take any daily chart and mark a virtual entry point. Now start with the weekly chart and just plot all horizontal support and resistance and all trend lines down to the hourly chart. I am relatively certain that people will no longer see the forest for the trees. If we proceeded in this systematic way, almost no trades could be found where the CRV was greater than 1. Therefore, we are forced to use only the “important” resistances and supports for our analysis. We are sorting out and this is another source of error.

CRV and Profit – Is there a connection?

Also, a fundamental question is, do profits increase when CRV increases? The following figure, which shows this correlation based on a strategy with the supertrend indicator, allows only one conclusion: you cannot generalize the correlations. A high CRV does not necessarily lead to a better result.

Chance-risk ratio-CRV-trader-correctly-evaluate-Rene-Berteit-GodmodeTrader.de-4

The interaction between CRV and probability is crucial for this result. Achieving bigger goals is just less likely. The greater our CRV, the less likely it is that this goal will be met. This means that there are two opposing effects. CRV has a mathematically positive effect on profit in euros, but the consequent decreasing probability has a negative effect. The central question is: which of the two opposing effects dominates? The above figure shows very clearly that we cannot give an overall and generally valid answer in this regard. In this case, the chart should have been steadily increasing (CRV compensates for probability loss) or steadily decreasing (CRV does not compensate for probability loss).

Summary

To one or the other, the current analysis of CRV may seem relatively theoretical, or at least mathematical. For this reason, however, knowledge of these is no less valuable. In the previous pages, we took a closer look at the risk-reward ratio and asked if this could be the key to success. At least this is how it is often expressed, according to the motto: Only trades that bring a large CRV and the profit will come by themselves.

It would be nice, but the reality is different. A large CRV has a positive influence on performance, but at the same time leads to a lower probability of achieving this goal as well. There is only an increase in performance if the performance improvement of the high CRV compensates for the disadvantages of the lower probability. Whether and with which CRVs this is the case cannot be said in general. This is explicitly dependent on the selected input signals & Co. Traditionally, a trade with a CRV of 3 would be rated better than one with a CRV of only 0.6. In reality, however, it may still be more successful to trade with 0.6 CRV.

Just because we see a 3:1 potential in the next trade doesn’t necessarily mean it’s a good trade idea. It would be too good to be true because why would we care about position size or entry if such a simple rule would lead to a successful strategy across the board. So if you are using the CRV as a trade evaluation benchmark, you should do so sensibly. Avoid the above mistakes and be aware of the relationship between CRV and probability (hit rate). In addition, you must always keep in mind the subjectivity with which we value the CRV. Here is another major source of error.

Reading tips: Risk analysis – How to assess your portfolio correctly!


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