Is it worth risking your time to benefit from this article?
The risk-reward ratio shows how much risk you will have to take based on the potential reward.
Experienced traders and investors weigh their chances carefully: they look for the highest upside potential and the lowest downside potential. If one investment produces the same return as another but with less risk, it will turn out to be a better bet.
Want to know how to calculate this ratio yourself? Let's figure it out.
Introduction
Whether you prefer day trading or swing trading, it is necessary to understand the fundamental concepts regarding risk. They form the basis of market understanding and guide trading activities and investment decisions. Otherwise, you will not be able to protect and increase your balance.
We have already discussed risk management, position sizing and stop loss setting. But if you are actively trading, ask yourself some important questions. What is the magnitude of the risk relative to the potential reward? How does upside potential compare to downside potential? In other words, what is your risk/reward ratio?
In this article, we will discuss how to calculate the risk-reward ratio for any trade.
What is the risk-reward ratio
The risk/reward ratio (R/R ratio or R) allows you to understand what risk a trader takes for the sake of potential reward. In other words, it shows you what your potential return is for every dollar you risk on an investment.
The calculation itself is very simple. The maximum risk is divided by the net target profit. How exactly? First, think about where you want to enter the trade. Decide where you will take profits (if the trade is successful) and where you will place the stop loss (if it is a losing trade). This is essential for effective risk management. Good traders set profit targets and stop losses before entering a trade.
Now you have entry and exit targets, meaning you can calculate your risk/reward ratio. To do this, you need to divide the potential risk by the potential profit. The lower this ratio is, the more potential profit you will get per “unit” of risk. Let's figure out how it works.
How to Calculate Risk-Reward Ratio
Let's say you want to go long on Bitcoin. You perform an analysis and determine that your take profit order will be 15% of the entry price. Next, you must answer the following question: where your position will be ineffective. This is where you will need to set your stop loss. In this case, you decide that your cancellation point will be 5% of your entry point.
It's worth noting that they generally should not be based on arbitrary percentage numbers. The profit target and stop loss must be determined based on market analysis. Technical analysis indicators are very useful to solve this problem.
So, our profit target is 15%, and the potential loss is 5%. What is the risk/reward ratio? 5/15 = 1:3 = 0.33. It's simple. This means that for every unit of risk we potentially win three times as much. In other words, for every dollar we risk, we can gain three dollars. So, if we have a position worth $100, then we risk losing $5 for a potential profit of $15.
We can also move our stop loss closer to our entry to reduce this ratio. However, entry and exit points should not be calculated arbitrarily, but solely on the basis of analysis. If a trading position has a high risk/reward ratio, it's probably not worth arguing with the numbers and hoping for success. In this case, we recommend choosing another position with a good risk-reward ratio.
Please note that positions of different sizes may have the same risk/reward ratio. For example, if we have a $10,000 position, we risk losing $500 for a potential profit of $1,500 (the ratio is still 1:3). The ratio only changes if we change the relative position of our target and stop loss.
Reward/Risk Ratio
It is worth noting that many traders do this calculation in reverse order - the profit/risk ratio. Why? It's just a matter of preference, some find it easier to figure out. The calculation here is exactly the opposite of the risk-to-reward ratio formula. That is, the reward/risk ratio in the example above would be 15/5 = 3. As you would expect, a high reward/risk ratio is better than a low ratio.
An example of a trading position with a profit/risk ratio of 3.28.
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What is risk and profit
Let's say we're at the zoo and we're having an argument. I'll give you 1 BTC if you sneak into the enclosure and hand feed the parrot. What is the potential risk? Obviously, you may be arrested by the police, but if successful, you will receive 1 BTC.
But there is an alternative option. I will give you 1.1 BTC if you climb into a tiger's cage and hand feed it raw meat. What is the potential risk now? Yes, you can still be arrested by the police, but in addition, a tiger can also attack you and cause fatal injuries. On the other hand, the profit potential is slightly higher than the parrot bet since you will receive more BTC if you are successful.
Which of these options seems more profitable to you? Technically both are unattractive because you wouldn't want to behave that way in a zoo. But with a tiger bet, you're taking on a lot more risk for a little more potential reward.
Likewise, many traders will select trading positions with the greatest profit and minimum risk. This is called asymmetric opportunity (potential gain is greater than potential loss).
It is also important to mention the win rate (success rate) here. Win rate is the number of winning trades divided by the number of losing trades. For example, if you have a 60% win rate, you make a profit on 60% of your trades (on average). Let's look at how to use this in risk management.
Even then, some traders can make profits with low win rates. Why is that? Just because of the risk/reward ratio of their individual trading positions. If they only take positions with a 1:10 risk/reward ratio, they can lose nine trades in a row and still be in the black on one trade. To make a profit, they will only need to win two out of ten trades. This is why calculating risk and reward is so important.
Summary
We looked at the risk/reward ratio and how traders can incorporate it into their trading plan. Calculating the risk-reward ratio is essential when determining the risk profile of any money management strategy.
Keeping a trading journal is also worth considering when it comes to risk. By documenting your trades, you will gain a more accurate understanding of the performance of your strategies, as well as tailor them to different market environments and asset classes.
