# Probability and risk reward in trading

## Probability and Risk Reward Ratio

For traders like you and me, stocks are nothing but electronic symbols. I only use volatility and liquidity to choose what stocks I trade. I will talk about why we need volatility and liquidity in the future. They are very easy to understand. The focus of today’s topic is Probability and Risk Reward Ratio (R-R-R). These two elements are a very crucial part of our trading career.

First, let me use a simple game to illustrate what probability is in trading. We all know that the probability of an outcome of flipping a coin is 50%. If you bet a rupee on the head and I bet a rupee on the tail. No matter how many times we play the game, we would break even in the end since the probability is 50%. Neither of us has an edge over the other. However, if you somehow increase your probability to 51%, you would beat me in the end. That is how casinos make money. Most people who go to casinos lose eventually. The house is always a winner since the odds are in the house’s favor. That is a probability.

Now let’s change the rules of the game. If you win, you make 2 dollars and if you lose, you lose 1 dollar. In other words, you risk a dollar to make 2 dollars. As for me, the rules are still the same. I risk one dollar to make one dollar. Your R-R-R becomes 1:2. Mine is 1:1. Probability is still 50%. It is not hard to see you will take all my money quickly. That is risk-reward-ratio.

Trading is not a zero-sum game since you will have to pay commissions to your broker. Even if your probability is 50% and Risk Reward ratio is 1:1, you’d still lose. So trading is a little bit harder than flipping a coin. Now it is quite obvious what we need to improve here. If you can prove that the accuracy of your system is over 55 percent no matter how the market behaves and your Risk Reward ratio is 1:1, then what a brain surgeon makes would seem like peanuts to you. It seems easy to trade with a Risk Reward Ratio of 1:1 since you really do not have to wait for a stock to move that much. However, the accuracy of your system is what you need to work on and it is extremely hard.