The risk-reward ratio assists traders in determining the profitability (return) of a trade’s prospective losses (risks). The Risk-Reward Ratio denotes the potential profit obtained for each and every dollar a trader invests. The trader sets the lines as a base for risk and rewards.
What is the Risk Reward Ratio?
In trading, this 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
Investor judges these factors themselves based on their risk tolerance capacity. It helps them manage their capital and loss risk.
The formula for the Risk Reward Ratio
The following formula helps calculate Risk Reward Ratio and helps the investors:
Risk / Reward ratio = Potential trading risk / Expected rewards
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:
Risk / Reward ratio = (Entry point – stop loss point) / (Profit target – entry point)
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
Risk Reward Ratio working
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.
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.
Risk / Reward Ratio = (180 – 170) / (200 – 180)
= 10 / 20
It indicates that the investment can give a double return.
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.