Should I risk my time to be rewarded with the information in this article?
The risk/reward ratio quantifies the risk you take in relation to the possible reward.
Good traders and investors choose their bets very carefully. They seek the combination of the greatest potential benefit with the lowest potential harm. If an investment can bring the same return as another, but with less risk, it may be a better option.
Want to know how to do this calculation? Keep reading.
Content
Introduction
What is the risk/reward ratio?
How to calculate the risk/reward ratio
The reward/risk ratio
Explanation of risk vs. reward
Final considerations
Introduction
Whether you are a day trader or a swing trader, there are some fundamental concepts about risk that you should understand. These concepts will give you a base to understand the market, so that you can direct your trading activities and investment decisions. Otherwise, you will not be able to protect and grow your wealth through trading.
We have already discussed risk management, position sizing, and defining stop-loss. However, if you are an active trader, there are some very important factors. How much risk are you taking in relation to the possible return? How does your upside potential compare to your downside potential? In other words, what is the relationship between risk and reward?
In this article, we will learn how to calculate the risk/reward ratio for your trades.
What is the risk/reward ratio?
The risk/reward ratio (R/R ratio or R) calculates the risk a trader has over the possible return. In other words, what are the potential rewards for every $1 invested.
The calculation is very simple. Simply divide the maximum risk by the target net profit. To make this calculation, you must first decide where you would like to invest. Then, you define at what point you would make profits (if the trade is successful) and what your stop-loss will be (if it is a negative trade). This is crucial for correct risk management. Good traders establish their profit targets and stop-loss before entering a trade position.
Now that you have your entry and exit points, you can calculate your risk/reward ratio. You do this by dividing your potential risk by your possible return. The smaller the proportion, the greater the possible return per “unit” of risk. Let's see how it works in practice.
How to calculate the risk/reward ratio
Let’s assume you want to enter a Long position for Bitcoin. You do your analysis and determine that your profit margin will be 15% in relation to the money invested. At the same time, you ask yourself the following questions. At what point will your trading idea be invalidated? It is at this point that you should set your stop-loss. In this case, you decide that your invalidation point is 5% of the entry value.
It is worth noting that these values should not be based on arbitrary percentage numbers, but rather on profit and stop-loss targets based on your analysis of the markets. Technical analysis indicators can be very useful.
So, our profit target is 15% and our potential loss is 5%. In this case, what is the risk/reward ratio? It is 5/15 = 1/3 = 0.33. This means that for each unit of risk, we have the potential to earn three times the amount invested. In other words, for every dollar at risk, we are likely to gain three. So, if we have a position worth $100, we risk losing $5 for a possible profit of $15.
We could even move our stop-loss closer to the entry value, however, as we have already discussed, the entry and exit points should not be calculated based on arbitrary numbers, but rather, on our analysis. If it is a trade with a high risk/reward ratio, it is probably not worth trying to “play” with the numbers. Maybe it's better to move on and look for another option where there is a better risk/reward ratio.
Note that some positions with different sizes may have the same risk/reward ratio. For example, if we have a position worth $10,000, we risk losing $500 for a possible profit of $1,500 (the ratio is still 1:3). The ratio only changes if we change the relative position of our target and the stop-loss.
The reward/risk ratio
It's worth noting that many traders do this calculation in reverse, calculating the reward/risk ratio. Why? Well, it's just a matter of preference. Some find this method easier to understand. The calculation is exactly the opposite of the risk/reward formula. In the case of the reward/risk formula, the ratio would be 15/5 = 3. As expected, a high reward/risk value is better than a low value.
Example of a trade setup with a reward/risk ratio of 3.28.
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Explanation of risk vs. reward
Let's suppose we are in a zoo and we make a bet. I will give you 1 BTC if you enter the birdhouse and feed a parrot from your hands. What is the potential risk? Well, that's not allowed, so you might be detained by the police. On the other hand, if you succeed, you will receive 1 BTC.
At the same time, I propose another alternative. I will give you 1.1 BTC if you enter the tiger's cage and feed it raw meat with your own hands. In this case, what is the potential risk? You can be detained by the police, of course. However, there is also a chance that you will suffer a tiger attack, which could end in a fatality. Considering the value of the bet, feeding the tiger would be a better option than the parrot as you would receive a little more BTC.
What seems like the best deal? Technically, both are bad deals, as none of this is allowed, much less recommended. However, you would be taking much more risk with the tiger bet, for a small difference in possible return.
Likewise, many traders opt for trade setups where they stand to gain much more than they have to lose. This is called an asymmetric opportunity (the potential upside is greater than the potential downside).
It is also important to mention the win rate. Your win rate is the number of positive trades divided by the number of negative trades. For example, if you have a 60% win rate, you are making a profit on 60% of your trades (on average). See how you can use this in risk management.
Still, some traders can be very successful with a very low win rate. Why? Because the risk/reward ratio in your individual trade setups adapts to this. If they only use setups with a risk/reward ratio of 1:10, they can make a loss on nine consecutive trades and still reach break-even on a single successful trade. In this case, it would only take two positive trades (out of ten) to make a profit. This is how the calculation of risk vs. reward can be very powerful.
Final considerations
In this article, we discuss what the risk/reward ratio is and how traders can incorporate it into their trading plans. When it comes to the risk profile of any financial management strategy, it is essential to calculate the risk/reward ratio.
When assessing risks, it is also worth considering the use of a trading diary. By recording your trades, you get more detailed insight into the performance of your strategies. Furthermore, you can adapt them to different market environments and asset classes.
Still have questions about calculating the relationship between risk and reward? Check out our Q&A platform, Ask Academy, where the Binance community answers your questions.
