Should I risk being compensated for the time I spend on this article?
The risk/reward ratio tells you how much risk you are taking for the corresponding potential reward.
Good traders and investors choose their bets carefully. They look for the highest upside potential and the lowest downside potential. If one investment can provide the same return as another, but with less risk, it may be a better bet.
Want to know how to calculate this for yourself? Let's see it together!
Introduction
Whether you day trade or swing trade, there are some fundamental concepts about risk that you need to understand. It is the basis of your understanding of the market and gives you a foundation to guide your trading activities and investment decisions. Otherwise, you will not be able to protect and grow your trading account.
We have already discussed risk management, position sizing and setting up Stop-loss. However, if you are actively trading, there is something important to understand. How much risk are you taking versus the potential reward? What is your upside potential versus your downside potential? In other words, what is your risk/reward ratio?
In this article, we will look at how to calculate the risk/reward ratio of your trades.
What is risk/reward ratio and how to use it?
The risk/reward ratio (R/R or R ratio) calculates the risk a trader takes for potential reward. In other words, it shows what the potential rewards are for every dollar you risk investing.
The calculation is simple: You divide your maximum risk by your target net gain. Here's how to do it. First, you search for an entry point. Then you decide where you will take your winnings (if the trade is successful) and where you will place your Stop-loss (if it is a losing trade). This is essential if you want to properly manage your risks. Good traders set their profit targets and loss threshold before entering a trade.
You now have your entry and exit targets, which means you can calculate your risk/reward ratio. To do this, you divide your potential risk by your potential reward. The lower the ratio, the higher the potential reward per “unit” of risk. Let's see how it works.
How to Calculate Risk/Reward Ratio
Let's say you want to enter a long position in Bitcoin. You perform your analysis and determine that your Take-profit order will be 15% of the entry price. At the same time, you also ask the following question. Where is our trade invalidated? This is where you should place your Stop-loss. In this case, you decide that your invalidation point is 5% from your entry point.
It should be noted that these figures should generally not be based on arbitrary percentages. You must determine the profit target and the Stop-loss based on your market analysis. Technical analysis indicators can be very useful.
So, our gain target is 15% and our potential loss is 5%. What is risk/reward ratio and how to use it? It is 5/15 = 1:3 = 0.33. Pretty simple, right? This means that for every unit of risk, we potentially gain triple the reward. In other words, for every dollar of risk we take, we stand to gain three dollars. So if we have a position worth $100, we stand to lose $5 for a potential profit of $15.
We could move our Stop-loss closer to our entry to decrease the ratio. However, as we said, entry and exit points should not be calculated based on arbitrary numbers. They must be calculated based on our analysis. If the trade setup has a high risk/reward ratio, it is probably not worth trying to “play” with the numbers. It may be best to continue and look for a different setup with a good risk/reward ratio.
Note that positions of different sizes can have the same risk/reward ratio. So, if we have a position worth $10,000, we risk losing $500 for a potential gain of $1,500, with the ratio remaining at 1/3. The ratio only changes if we modify the relative position of our target and our Stop-loss.
The reward/risk ratio
It should be noted that many traders perform this calculation in reverse, calculating the reward-to-risk ratio instead. For what ? It's just a matter of preference. Some find this easier to understand. The calculation is just the inverse of the risk/reward ratio formula. So, our reward-to-risk ratio in the example above would be 15/5 = 3. As you might expect, a high reward-to-risk ratio is better than a low reward-to-risk ratio.
Example trade setup with a reward/risk ratio of 3.28.
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Risk and reward explained
Let's say we're at the zoo and we make a bet. I will give you 1 BTC if you sneak into the birdhouse and feed a parrot with your own hands. What are the risks ? Well, since you are doing something you shouldn't be doing, you might get arrested by the police. On the other hand, if you succeed, you will obtain 1 BTC.
At the same time, it has its drawbacks. I will give you 1.1 BTC if you sneak into the tiger's cage and feed it raw meat with your bare hands. What is the potential risk here? You can get arrested by the police, of course. But, there is a chance that the tiger will attack you and inflict fatal injuries. On the other hand, the reward is a little better than for the parrot bet, because you get a little more BTC if you succeed.
What is the best choice ? Technically, these are both bad ideas, you should avoid doing such things. However, you are taking on a lot more risk with the tiger bet for only a little more potential reward.
Likewise, many traders look for positions where they stand to gain much more than they stand to lose. This is called an asymmetric opportunity (the potential upside is greater than the potential downside).
It is also important to mention your success rate here. Your win rate is the number of your winning trades divided by the number of your losing trades. For example, if you have a success rate of 60%, you make profits on 60% of your trades (on average). Let's see how you can use it in your risk management.
However, some traders can be very profitable with a very low success rate. For what ? Because the risk/reward ratio of their individual trading setups lends itself to it. If they only accept setups with a 1:10 risk/reward ratio, they could lose on 9 trades in a row and break even with just one winning trade. In this case, they would only have to win two out of ten deals to be profitable. This is how the risk/reward calculation can be very beneficial.
To conclude
We've looked at what risk/reward is and how traders can incorporate it into their trading plan. Calculating the risk/reward ratio is essential when it comes to defining the risk profile of a wealth management strategy.
What is also worth considering when it comes to risk is keeping a trading journal. By documenting your trades, you can have a more precise view of the performance of your strategies. Additionally, you can potentially tailor them to different market environments and asset classes.
