What Is the Risk/Reward Ratio and How to Use It
Using the risk/reward ratio, you can figure out what amount of risk you are taking for how much potential reward you are expecting. A good trader or investor chooses their bets very carefully before they invest their money. In other words, they look for opportunities with the highest upside potential and the lowest downside potential. It may be a wise move for an investor to make an investment that provides the same yield as another, but with less risk.
Introduction
The fundamental concepts of risk should be understood by all traders, regardless of whether they are day traders or swing traders. Your understanding of the market is derived from these principles, and they serve as a guide to your trading activities and investment decisions. Otherwise, you will not be able to protect and grow your trading account.
Several topics have already been covered, such as risk management, position sizing, and setting a stop loss. It is important to understand, however, something crucial if you are actively trading. You need to understand just how much risk you’re taking compared to the potential reward. How do you compare the potential upside and downside? In other words, what is the risk/reward ratio for your investment?
We will discuss risk/reward ratios for trading in this article.
What is the risk/reward ratio?
An investor's risk/reward ratio (R/R ratio or R) evaluates how much risk the investor is taking for how much potential reward they are getting. In other words, it provides a way to show how much you can expect to receive for each $1 you risk.
It is very simple to calculate these returns. Simply divide your maximum risk by your target net profit. How do you calculate this? To begin with, you take into consideration where you would like to enter the trade. In order to take profit, you need to determine where to place your stop-loss (in the case of a losing trade), and where to take profits (in the case of a successful trade). Making such decisions is essential to the process of managing your risk correctly. Before entering a trade, successful traders set their profit targets and their stop-loss.
Now that you've identified your entry and exit points, you're in a position to determine your risk/reward ratio. To calculate it, divide your potential reward by the potential risk. In general, the lower the risk-reward ratio, the greater the potential reward per unit of risk. Let us examine how this works in practice.
How to calculate the risk/reward ratio
let us consider a situation where you want to take a position long in Bitcoin. During your analysis, you figure out that you will take a 15% profit from your entry price at the time of your take profit order. However, this raises the following question. When did your trade idea get invalidated? In that case, you should place your stop-loss order. In this case, it might be appropriate to set your invalidation point at 5% of your entry point.
It should be noted that arbitrary percentages should not be used in these calculations. According to your evaluation of the markets, you should set your profit target and stop-loss accordingly. Technical analysis indicators can be extremely useful in this regard.
As a result, our profit target is 15%, and we are assuming a potential loss of 5%. So, how would you rate the risk-reward ratio? The answer is 5/15 = 1:3 = 0.33. The result is that we could potentially obtain three times the reward for each unit of risk that is taken. As a result, we are more likely to gain three times the amount we risk for each dollar we put at risk. In other words, if the position is worth $100, we risk losing $5 in order to make a profit of $15.
We may be able to decrease this ratio by moving our stop loss closer to the entry point. In any case, we have previously stated that we shouldn't calculate entry and exit points using arbitrary numbers. The points should be determined based on our analysis. It is unlikely to be worthwhile to attempt to "game" the numbers in a trade setup with a high risk/reward ratio. There may be a better option to move on and find another setup that has a better risk-reward ratio.
It should be noted that positions with different sizings can have the same risk/reward ratio. A position worth $10,000, for example, will result in a potential loss of $500 for a potential profit of $1,500 (the ratio is 1:3). Our target and stop-loss ratio changes only if our target and stop-loss positions are moved relative to each other.
Risk vs. reward explained
Let's suppose we were at the zoo and we decided to place a BET. You will receive 1 Bitcoin if you sneak into the bird house and feed a parrot from your hands. How risky is it? Since you are doing something that you aren't supposed to be doing, you may be taken away by the police. In contrast, if you are successful, you'll receive 1 BTC when you complete the task.
In addition, I offer an alternative. There's 1.1 BTC I'm going to give you if you sneak into the tiger cage with your bare hands and feed raw meat to the tiger. Is there any risk involved? It might be that the cops take you away from that. You are also at risk of being attacked by a tiger who could inflict fatal damage on you. Nevertheless, it has a slightly better upside than the parrot bet because you get a bit more BTC after winning, as opposed to a smaller payout.
What do you think? It is technically true that these are both bad deals, because you should not be sneaking around like that. However, you are taking on a much greater risk with the tiger bet for only a somewhat greater potential reward.
As a result, many traders will look for potential trade setups that can significantly increase their chances of profit compared to their risk of loss. The potential upside for this investment is greater than the potential downside, which is referred to as an asymmetric opportunity.
Your win rate is also important to consider in this scenario. By dividing the number of winning trades by the number of losing trades, you can determine your win rate. If you have a 60% win rate, this means that on average you are making profit from 60% of your trades.
Nevertheless, some traders are able to make a high amount of profit despite a very low winning rate. But why? In the case of individual trade setups, the risk/reward ratio of each setup accounts for this. A trader could lose nine trades in a row if they only took setups with a risk/reward ratio of 1:10, but still break even on just one trade. In this instance, it is only necessary that they win only two trades out of ten in order to be profitable. That is one of the advantages of using risk vs. reward calculations.