Trade Graphs | Risk/Reward Ratio

Modified on 2012/11/17 12:32 by Eugene — Categorized as: Visualizers

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Most successful money managers think in terms of risk/reward. This visualizer helps you understand how your profits and losses are related to your initial risk.

The risk/reward ratio, as Investopedia states, is a ratio that compares "the expected returns of an investment to the amount of risk undertaken to capture these returns". This ratio is calculated by simply dividing the amount of profit or loss the trader expects to have made when the position is closed (i.e. the projected profit) by the amount that could be lost if price moves in the opposite direction (i.e. the risk). The entry risk is defined as the difference between the entry price and the initial stop price. A rule of thumb is to aim for a reasonable risk/reward ratio of at least 2:1.

The visualizer consists of two graphs, Distribution (upper) and Contribution (lower).

Distribution

The risk/reward Distribution graph processes all closed and open trades in the simulation, showing both winning and losing trades (accordingly, green and red bins). The X axis contains the risk/reward bins (equal to the number of trades or 10, whichever is less).

These bins aggregate the simulated trade results expressed as risk/reward ratio. A bin contains all trades with a risk/reward value up to the bin value and less. For example, let's take the figure above. The "2" bin, preceded by the "1.5" bin, groups all trades with risk/reward ratio from 1.5:1 to 2:1. In this case, the "2" bin has 1 trade which risk/reward was 2:1. The Y axis indicates the number of trades in a particular bin. The histogram also shows that losing trades (red bars) shows that most losers were packed in the "1" bin, i.e. have a risk/reward ratio from -1:1 to -0.51:1. The adjacent two red bins, -0.5 and 0, have comprised losing trades which risk/reward was ranging from -0.99:1 to -0.5:1 and from -0.49:1 to 0, respectively.

Contribution

The risk/reward Contribution histogram is similar to Distribution. It also includes all closed and open trades in the simulation, showing both winning and losing trades. The difference is that this histogram shows how a particular "bin" contributed to the risk/reward picture, providing profit contribution as a function of trade's risk/reward ratio.

The X axis contains the risk/reward bins (equal to the number of trades or 10, whichever is less). Winning and losing bins are colored green and red accordingly. The Y axis contains the combined total amount of risk/reward units generated by trades in a bin.

These bins aggregate the simulated trade profit or loss expressed as risk/reward ratio. A bin contains the accumulated contribution of a particular risk/reward group. For example, the "2" bin on the figure above contains trades with risk/reward ratios less than or equal to 2. In this case, there was 1 trade with risk/reward ratio 2:1.

On a final note, keep in mind that your risk/reward analysis is somewhat limited if it doesn't account for the winning percentage as well as time in the trade - although more subtle, but still a risk.

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