Many discretionary traders swear by risk-reward ratio, as in "The minimum risk-reward ratio for a Forex trade is 1:2."
Do quantative traders use risk-to-reward ratio as well? If so, how do you calculate the minimum risk-reward ratio?
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Sign up to join this communityMany discretionary traders swear by risk-reward ratio, as in "The minimum risk-reward ratio for a Forex trade is 1:2."
Do quantative traders use risk-to-reward ratio as well? If so, how do you calculate the minimum risk-reward ratio?
Maximizing expected return while minimizing risk is at the heart of the quantitative revolution in finance in modern portfolio theory.
Starting with Harry Markowitz (1952) "Portfolio Selection", a huge portion of quantitative finance is dedicated to refining the ideas around mean-variance portfolio optimization. The objective is to find a weight vector $w$ that will minimize:
$$w^T \Sigma w$$
subject to:
$$R^T w = \mu$$
When evaluating performance, the Sharpe ratio is the most widely used performance measure, and it directly (if a little crude) addresses the trade-off between risk and reward.
$$S = \frac{E[R-R_f]}{\sqrt{\mathrm{var}[R]}}$$
I recommend reading Peter Bernstein's "Capital Ideas" as a gentle introduction to this subject.