Risk-to-Reward Ratio: Calculation, Importance and Benefits
20 October 2022
The stock market is one of the riskiest places to invest and generate returns. Whether you’re just starting out or a seasoned trader or investor, every trade you make carries some level of risk. The amount of risk you’re willing to take in order to make a certain amount of profit should be considered before each trade. This comparison is made using the Risk/Reward Ratio or Risk-to-Reward ratio (abbreviated as R/R).
Read on to understand what is risk/reward ratio, its formula and calculation, importance, the ideal R/R ratio and its benefits and limitations.
What is Risk/Reward Ratio?
The Risk-to-Reward ratio is used to weigh a trade’s potential profit (reward) against its potential loss (risk). The R/R ratio is used by stock traders and investors to determine the price at which they will exit a trade, regardless of whether it generates a profit or a loss. A stop-loss order is typically used to exit a position if it begins to move in the opposite direction that the trader anticipated.
The risk-reward relationship helps determine whether the expected returns outweigh the risk and vice versa. In short, the RR ratio assists traders in determining whether a particular trade is worthwhile. The ratio is computed by dividing the amount a trader stands to lose if the price of an asset moves unexpectedly (the risk) by the amount of profit the trader anticipates making when the position is closed (the reward).
How Does the Risk-Reward Ratio Work?
Market strategists frequently find that the ideal risk/reward ratio for their investments is around 1:3, or 3 units of expected return for each unit of additional risk. Investors can more directly manage risk and reward by using stop-loss orders and derivatives such as put options.
When trading individual stocks, the risk/reward ratio is frequently used as a metric. The optimal risk/reward ratio varies greatly between trading strategies. Many investors have a pre-specified risk/reward ratio for their investments, while some trial-and-error methods might be required to determine which ratio is best for a given trading strategy.
The risk/reward ratio assists in calculating losses and profits and provides a reason to think twice before entering a trade. Additionally, before finishing trading, one should determine how much one can afford to lose today and in each trade.
If you see a trade that looks appealing due to price formations, economic factors, or your intuition, you can afford to take on more risk and have a risk/reward ratio of 1:2, 1:1, or even 1:0.5. It’s fine as long as you understand why you’re doing it and keep your emotions in check.
Furthermore, the lower your risk reward ratio (1:3 is not too low, but 1:5 is indeed a low R/R ratio), the lower your chances of profiting in the trade. It occurs as a result of market volatility, which can cause the chart to move to your Stop Loss and then reverse to your targets. To succeed, you should strike a balance between the R/R ratio and the trade’s win rate.
Every venture in the market that involves any kind of return necessitates some level of risk. Avoid making emotional decisions because they can alter your predetermined financial goal and lead you to make inconsistent bets. To take a calculated risk, a risk-to-reward ratio is always required.
Risk-Reward Ratio Formula
To calculate the risk-reward ratio, the investor must first determine the risk of the transaction. After determining the risk, they must determine the expected rewards that will result from taking on the involved potential risk of losing the money invested. Finally, once the potential risk and expected rewards have been determined, the risk reward ratio can be computed by dividing the potential risk by the expected rewards in trading. The risk reward ratio formula is as follows:
Investors consider the ratio when trading stocks because it helps them assess their expected return as well as the risk associated with such a transaction. The ratio varies from one strategy to the next, i.e., it does not remain constant and varies depending on the person’s strategy.
As a result, the trader must judge the expected return and the risk associated with it in order to calculate the risk-reward ratio. Given by the stop-loss order, the risk is the total potential loss that might occur. It is given by the difference between the trade’s entry point and the stop-loss order. Reward, on the other hand, is the total potential profit that is established by a profit target. This is the point where security is sold. It can be computed by taking the difference between the profit target and the entry point.
How to Calculate the Risk Reward Ratio?
Assume you want to take a long position in Bitcoin. You conduct your research and determine that your take profit order will be 30% higher than your entry price. You also ask the following question at the same time. Where has your trade idea been invalidated? That is where your stop-loss order should be placed. In this case, assume you chose a 10% deviation from your entry point as your invalidation point.
It should be noted that these should not be based on arbitrary percentages, rather they should be based on your market analysis, after which you should set the profit target and stop loss. Technical analysis indicators can be extremely beneficial in determining these.
As a result, our profit goal is 30% and our potential loss is 10%. Now the calculation is straightforward:
Potential Loss / Potential Profit = Risk Reward Ratio
It is 10/30 = 1:3 = 0.33 in this case. This means that for every unit of risk, we could win three times the reward. In other words, for every dollar we risk, we stand to gain three. So, if we have a $100 position, we risk losing $10 for a potential $30 profit. It should be noted that positions of varying sizes can have the same risk reward ratio. Only the relative position of our target and stop-loss causes the ratio to change.
Stop-loss and Take Profit in Risk Reward Ratio Calculation
Stop-loss and take-profit levels are price targets that traders set in advance for themselves. These predetermined levels, which are often used as part of a disciplined trader’s exit plan, are aimed to limit emotional trading to a minimum and are vital to risk management.
A stop-loss (SL) level is the price of an asset that is set below the current price at which the position is closed in order to limit an investor’s loss on a particular investment. A take-profit (TP) level, on the other hand, is a predetermined price at which traders end a profitable position after they are satisfied with the amount.
Trading methods like the Risk Reward Ratio make sense only when combined with trading tools like stop-loss and take-profit levels.
What is the Ideal Risk-to-Reward Ratio?
The risk reward ratio can be calculated mathematically, but the idea is to enter a trade where the profit potential exceeds the loss potential. A risk-to-reward ratio of 1:3 in other words, you risk $1 but have the potential to gain $3 is considered optimal by many crypto investors and is frequently written as “0.3” in calculation formulas. The risk-to-reward ratio can be less than 0.3, but taking a higher risk reduces your chances of profit, whereas taking a lower risk does not always result in a decent profit. A maximum risk/reward ratio of 0.5 is recommended. With this ratio, you have a better chance of profitability.
Advantages & Disadvantages of Risk-to-Reward Ratio
Following is the risk reward ratio table showing its advantages and disadvantages:
Risk management – This ratio approximates the possible reward of an investment versus the risk that the investor is willing to accept. It is stated as a price; for example, a risk/reward ratio of 1:5 means that an investor will risk $1 for the prospect of gaining $5. This is referred to as the anticipated return. Calculating risk/reward ratios is a crucial aspect of risk management, particularly when trading in volatile markets when the risk outweighs the potential return.
Not a sufficient indicator by itself- Although it is a good indicator, not all decisions can be based only on this. Other measures must be used in conjunction to arrive at the proper investment decision.
Checking the worth of investment – Even if the investment does seem to be profitable, using the Risk To-Reward ratio would help in ascertaining if the reward is worth the risk. For example, an investor may select between low-risk investments such as bonds, debentures, and fixed deposits, which give a lesser return on investment, and higher-risk assets such as stocks and mutual funds, which provide larger yields but also carry the risk of loss. An investor’s expectations and risk tolerance impact their investment choices.
Lack of precision and accuracy- The risk/reward ratio is not always accurate; the investor must make a decision based on their risk appetite and price movement expectations. Although technical and fundamental analysis help to improve understanding of risk/reward ratios in stocks, they are not completely accurate and still contain assumptions. The Risk-to-Reward ratio is based on the expectation of a specific movement, but financial instruments in the market do not always move in the predicted or opposite direction. When a stock remains unchanged for an extended period of time, it becomes a dead investment with neither profit nor loss.
How to Make an Informed Decision With a Risk/Reward Ratio?
One of the most important factors that traders and investors should consider before entering a trade is the Risk-to-Reward ratio. After determining the R/R ratio for a trade, you can place a stop-loss order to limit your losses. Similarly, you can use the book profit order to exit the position at the price you want.
If the risk/reward ratio is greater than 1.0, the potential risk outweighs the potential reward. If the risk/reward ratio is less than 1.0, the potential reward is greater than the potential risk. Generally, any investment with a risk/reward ratio of 0.25-1.0 will generate some income. The majority of day traders will advise you to look for investments with a low risk/reward ratio.
In investing, there are always potential risks and rewards. The risk/reward ratio can help you determine whether the potential losses and gains are worthwhile. This ratio is an important tool for making informed decisions. You can use the Risk-to-Reward ratio to improve your investments with a little research and simple math. Keeping a trading journal is also something to consider when it comes to risk. You can get a more accurate picture of the performance of your strategies by documenting your trades. It would also help adapt to different market environments and asset classes and make better investment decisions.
But if you are not sure if you should trade yet, you can invest a small sum every month in mutual funds. Start an SIP with Navi Mutual Fund at just Rs.500 per month. Download the Navi App now!
Q1. What is meant by stop-loss and take-profit levels?
Ans: A stop-loss (SL) level is the price of an asset that is set below the current price at which the position is closed in order to limit an investor’s loss on a particular investment. A take-profit (TP) level, on the other hand, is a predetermined price at which traders end a profitable position after they are satisfied with the amount.
Q2. What is the best risk reward ratio?
Ans: The risk/reward ratio can be calculated mathematically, but the idea is to enter a trade where the profit potential exceeds the loss potential. A risk/reward ratio of 1:3 in other words, you risk $1 but have the potential to gain $3 is considered optimal by many crypto investors and is frequently written as “0.3” in calculation formulas. The risk/reward ratio can be less than 0.3, but taking a higher risk reduces your chances of profit, whereas taking a lower risk does not always result in a decent profit. A maximum risk/reward ratio of 0.5 is recommended.
Q3. How to calculate the Risk reward ratio?
Ans: One can use a risk reward calculator/risk reward ratio calculator or compute it using the formula given by Risk reward ratio = Potential Trading Risk / Expected Trading Rewards. It should be noted that positions of varying sizes can have the same risk reward ratio. Only the relative position of our target and stop-loss causes the ratio to change.
Q4. What decision can be made from the Risk reward ratio?
Ans: If the risk/reward ratio is greater than 1.0, the potential risk outweighs the potential reward. If the risk/reward ratio is less than 1.0, the potential reward is greater than the potential risk. Generally, any investment with a risk/reward ratio of 0.25-1.0 will generate some income. The majority of day traders will advise you to look for investments with a low risk/reward ratio.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
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