Should I risk my time to get the information in this article in return?
The risk-return ratio reflects the corresponding risk taken to obtain a certain potential return.
Good traders and investors choose their bets very carefully. They seek investments with the least potential downside and the greatest potential upside. If one investment can deliver the same return as another, but with less risk, it may be the better choice.
Are you interested in learning how to calculate your own risk-reward ratio? Read this article to find out.
Introduction
Whether you choose day trading or swing trading, you should understand some basic concepts about risk. These will give you some initial understanding of the market and provide you with a foundation to guide your trading activities and investment decisions. Otherwise, you will not be able to protect the funds in your trading account and make them bigger.
We've talked about risk management, position sizing, and setting stops. But if you're using an active trading strategy, there are some crucial things you need to understand. How big is your risk relative to your potential reward? What is your potential advantage versus your potential disadvantage? In other words, what is your risk-reward ratio?
In this article, we will discuss how to calculate the risk-reward ratio of a trade.
What is the risk-reward ratio?
The risk-reward ratio (expressed as the R/R ratio or R) calculates the amount of risk a trader is taking for a given potential reward. In other words, it shows the potential return you can get for every $1 you invest.
The calculation itself is simple, just divide your maximum risk by your net target profit. How do you do it? First, look at the price point where you want to open a trade. Then, decide where to take profit (if the trade is a success), and where to place your stop loss (if the trade is a loss). This is crucial if you want to manage your risk in a proper manner. Good traders set profit targets and stop losses before opening a trade.
Now that you have your entry and exit targets in place, you can calculate your risk-reward ratio. Simply divide your potential risk by your potential reward. The lower this ratio, the greater your potential return per "unit" of risk. Let's look at how this actually works.
How to Calculate Risk-Reward Ratio
Suppose you want to open a long position on the Bitcoin platform. After analysis, you decide to take profit at a price 15% higher than the entry price. At the same time, you also ask the following question. At what price will your trading idea be invalidated? In other words, where do you plan to set a stop loss order. In this case, you decide to set the invalidation position to 5% below the entry price.
It is worth noting that this percentage cannot usually be chosen randomly. You should determine when to take profit and stop loss based on your analysis of the market. Technical analysis indicators can help you do this.
Now, our profit target is 15%, and our potential loss is 5%. What is the risk-reward ratio? The calculation is: 5/15 = 1:3 = 0.33. It's that simple. This means that for every unit of risk investment, we have the potential to get three times the return. In other words, for every dollar we risk, we may also triple. So if we hold a position worth $100, we may get a potential profit of $15 at the cost of losing $5.
We can lower this ratio by moving the stop loss closer to the entry price. However, as we said, entry and exit positions should not be calculated based on arbitrary numbers, but on rational analysis. If a trading combination has a high risk-reward ratio, it may not be worth trying to "game" the numbers. It is better to continue looking for other setups with a good risk-reward ratio.
Note that positions of different sizes can have the same risk-reward ratio. So if we hold a position worth $10,000, we are losing $500 to gain a potential profit of $1,500 (still a 1:3 ratio). The ROI changes only if we change the relative position of our take-profit target and stop-loss.
Risk-Reward Ratio
It is worth noting that many traders do this calculation the other way around, calculating the reward-to-risk ratio. Why do they do this? It is just a personal preference. Some people find it easier to understand. It is the exact opposite of the risk-to-reward formula. So, in the example above our reward-to-risk ratio is: 15/5 = 3. As you might imagine, a higher reward-to-risk ratio is better than a lower reward-to-risk ratio.
Example of a trading combination with a reward-to-risk ratio of 3.28.
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Risk and Reward Analysis
Let's say we make a bet at a zoo. If you sneak into the aviary and hand-feed a parrot, I'll give you 1 bitcoin. What's the potential risk of doing this? The risk is that you'll do something you shouldn't and get picked up by the police. But if you succeed, you'll get 1 bitcoin.
At the same time, I also propose an alternative. If you sneak into the tiger cage and feed the tiger raw meat with your bare hands, I will give you 1.1 Bitcoins. What are the potential risks of doing this? You may still be taken away by the police. But you may also be attacked by the tiger and be fatally injured. On the other hand, the reward is a little better than the bet of feeding the parrot. Because if you succeed, you will get more Bitcoins.
Which one looks like a better deal? Strictly speaking, neither is a good deal, since you shouldn't sneak into a zoo. Still, you're taking a bigger risk with the tiger-feeding bet for only a slightly greater potential reward.
Likewise, many traders look for trades where the gains are greater than the losses they sustain. These are called asymmetric opportunities (the potential upside is greater than the potential downside).
Another thing to mention here is your win rate. Your win rate is the number of winning trades divided by the number of losing trades. For example, if your win rate is 60%, it means that 60% of your trades will be profitable (this is an average ratio). Let's understand how to apply this ratio in your risk management.
Even so, some traders are able to achieve high profits with a very low win rate. Why is this? Because the risk-reward ratio of their individual trading portfolio is matched. If they only choose a portfolio with a risk-reward ratio of 1:10, they may lose 9 trades in a row and still break even on the remaining one. In this case, they only need to win two trades out of ten to make a profit. This is the power of risk-reward calculations.
Summarize
We have covered what the risk-reward ratio is and how traders can incorporate it into their trading plans. Calculating the risk-reward ratio is essential to understanding the risk profile of any money management strategy.
When it comes to risk, you should also consider keeping a trading journal. By recording your trades, you can get a more accurate picture of your strategy’s performance. In addition, you can flexibly apply it to different market environments and asset classes.
