Let’s say we’re at the zoo and we make a bet. I’ll give you 1 BTC if you sneak into the birdhouse and feed a parrot from your hands. What’s the potential risk? Well, since you’re doing something you shouldn’t, you may get taken away by police. On the other hand, if you’re successful, you’ll get 1 BTC.
At the same time, I propose an alternative. I’ll give you 1.1 BTC if you sneak into the tiger cage and feed raw meat to the tiger with your bare hands. What’s the potential risk here? You can get taken away by police, sure. But, there’s a chance that the tiger attacks you and inflicts fatal damage. On the other hand, the upside is a little better than for the parrot bet, since you’re getting a bit more BTC if you’re successful.
Which seems like a better deal? Technically, they’re both bad deals, because you shouldn’t sneak around like that. Nevertheless, you’re taking much more risk with the tiger bet for only a little more potential reward.
In a similar way, many traders will look for trade setups where they stand to gain much more than they stand to lose. This is what’s called an asymmetric opportunity (the potential upside is greater than the potential downside).
What’s also important to mention here is your win rate. Your win rate is the number of your winning trades divided by the number of your losing trades. For example, if you have a 60% win rate, you are making profit on 60% of your trades (on average). Let’s see how you can use this in your risk management
Even so, some traders can be highly profitable with a very low winning rate. Why? Because the risk/reward ratio on their individual trade setups accommodates for it. If they only take setups with a risk/reward ratio of 1:10, they could lose nine trades in a row and still break-even
in one trade. In this case, they’d only have to win two trades out of ten to be profitable. This is how the risk vs. reward calculation can be powerful.