What is a Risk Reward Ratio? | Definition and Example

The risk reward ratio helps traders assess the profitability of a trade by comparing potential gains (return) to prospective losses (risks), indicating the potential profit for every dollar invested. The trader sets the lines as a base for risk and rewards. 

Risk Reward Ratio in a nutshell

  • Risk reward ratio assesses trade profitability by comparing potential gains to prospective losses.
  • A ratio greater than one suggests a bigger potential risk than return, while lesser than 1 indicates lesser risk than rewards.
  • Day traders typically keep the ratio between 1 and 0.25.
  • In binary options trading, the risk reward ratio is less than 1:1.

Understanding the Risk Reward Ratio

In trading, the risk reward ratio calculates the probable earnings and losses from a trade. The traders determine it by dividing expected rewards by potential risks.

The two determinants have the following explanations:

  • Potential risk refers to losses on the money invested in the trading
  • Reward refers to the expected earnings an investor wishes to earn to undertake the potential risk

The investor judges these factors themselves based on their risk tolerance capacity. It helps them manage their capital and loss risk.

Taking trades with a lower Risk Reward Ratio is better in isolation. The opportunity for profit surpasses the risk and produces excellent results. Day traders keep the ratio between 1 and 0.25. It is critical to place stop-loss logically and use strategy and analysis for profit targets. 

The formula for the Risk Reward Ratio

The following formula helps calculate Risk Reward Ratio and helps the investors:

A stop-loss order helps assess risk value. Risk is the price difference between the trade entry points and stop-loss orders. Reward gets established by a profit target, which is a point of selling security. It indicates total trade gains and is measured through the difference between the profit target and entry point.

Thus, another way to calculate the Risk Reward Ratio is:

The relationship between two numbers is visible as follows:

  • A ratio greater than one suggests that the transaction has a bigger possible risk than the return.
  • A Risk Reward Ratio lesser than 1 indicates a lesser transaction risk than the expected rewards. 

For example, a trader purchases a stock at an entry point of $25.60 and places the stop-loss at $25.50 and a $25.85 profit target. The Risk Reward Ratio is as follows:

(25.60 – 25.50) / (25.85 – 25.60) = 0.10 / 0.25 = 0.4

A risk reward ratio of 0.4 means that for every dollar the trader risks, the trader is looking to make a profit of 40 cents. This suggests that the trader is willing to accept a higher risk in relation to the potential gain in that particular trade.

Example of the Risk Reward Ratio

An investor conducts market research and analyzes various companies’ stocks. He expects the stock price of AB to go to $200 per share from the current price of $180. The investor will sell the share at $200. Similarly, a huge potential loss may occur if the share price goes down beyond $170 per share. So, he places stop-loss at $170. The Risk-Reward Ratio is as follows:

Risk-Reward Ratio: (180 – 170) / (200 – 180) = 0.5

The Risk-Reward Ratio of 0.5 in this example means that for every $1 of risk (potential loss if the share price drops to $170), there is an expected reward of $2 (potential gain if the share price rises to $200).

What is the Risk Reward Ratio in Binary Options Trading?

Binary options inherently offer a risk-reward ratio that’s less than 1:1. While brokers often tout high percentage returns, the reality is harsher. When a trade ends in loss, the entire investment is gone – a 100% loss. Returns typically range from 65% to 92%, depending on the broker, meaning the risk-to-reward ratio is skewed.

For example, if one were to trade gold with an 86% payout, the risk-to-reward ratio would be 1:0.86. Put simply, for every dollar invested, a successful trade yields only 86 cents in profit, while a losing trade wipes out the investment. Given this fixed ratio, it takes more than one successful trade to recover losses, placing the odds against traders from the start.

Summing up

The investor uses the Risk-Reward Ratio to measure expected rewards for the investor at the given level of potential risk. It helps them significantly in decision-making regarding trading investment. The investor can assess his risk-taking capacity and take action accordingly. They can apply several techniques to make this ratio as accurate as possible.

About the author

Percival Knight
Percival Knight is an experienced Binary Options trader for more than ten years. Mainly, he trades 60-second trades at a very high hit rate. My favorite strategies is by using candlesticks and fake-breakouts

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