Sizing Positions for Asymmetric Risk/Reward
How a trade's risk/reward ratio can inform position sizing, beyond a fixed percentage rule alone.
What to remember
- A fixed-percentage risk rule is a reasonable baseline, but doesn't account for a trade's specific risk/reward ratio.
- A more favorable risk/reward ratio can justify a different sizing approach, holding probability constant.
- Risk/reward ratio alone says nothing about the actual probability of success.
- Meaningful position sizing considers both risk/reward ratio and win probability together.
Beyond a flat position-sizing rule
A simple fixed-percentage risk rule (such as risking 2% of an account per trade) is a reasonable baseline, but doesn't distinguish between a trade offering a 1:1 risk/reward ratio and one offering 4:1 — some traders adjust position size based partly on a specific trade's risk/reward profile.
The general idea
A trade with a more favorable, asymmetric risk/reward ratio (small potential loss relative to a larger potential gain) can justify a somewhat different sizing approach than a trade with a weaker ratio, even holding win probability constant.
A real caution
- An attractive risk/reward ratio alone says nothing about the actual probability of the favorable outcome occurring.
- Sizing decisions that ignore win probability entirely, based on risk/reward ratio alone, can still be poorly calibrated.
Risk/reward ratio and win probability are both necessary inputs
A favorable risk/reward ratio with a very low win probability, or a strong win probability with a poor risk/reward ratio, can both be poor trades — meaningful sizing decisions need both inputs together, not either one alone.
Risk/reward ratio and win probability together, not either one alone -- a strong ratio with weak odds or strong odds with a weak ratio can both still be poor trades.
What to remember
- A fixed-percentage risk rule is a reasonable baseline, but doesn't account for a trade's specific risk/reward ratio.
- A more favorable risk/reward ratio can justify a different sizing approach, holding probability constant.
- Risk/reward ratio alone says nothing about the actual probability of success.
- Meaningful position sizing considers both risk/reward ratio and win probability together.