Risk-reward is a useful concept in financial trading and investing. It refers to a potential profit of a trade or investment compared to its loss. In most cases, it is seen as the difference between the entry of a trade and where you set your stop loss.
This ratio is not something shared, but each trader decides their own ratio based on their risk appetite.
In this article, we will look deeply at the concept of risk and reward and how you can use it in trading.
Definition of risk/reward
Trading is a risky activity that you can do, which explains why so many people who start doing it fails. It is estimated that over 80% of people who start day trading end up in failure for one reason or the other. For example, people fail because of opening extremely big trades or being over-leveraged.
Therefore, risk/reward ratio is a concept that looks at the amount of risk you are exposing yourself to compared with the potential profit. For example, if you are risking $10 with the goal of making $20, then the risk and reward ratio, in this case, is 10/20, which is equivalent to ½.
As mentioned above, risk/reward is also seen as the difference between where you enter a trade and where you set the stop-loss. For starters, a stop-loss is a tool that automatically stop a trade when it reaches a certain loss threshold.
Assuming that you opened a buy trade at $10 and you set a stop-loss at $8, your trade will be stopped immediately when it hits $8. As such, even when the asset crashes to $5, you will be partially safe.
Therefore, having a good risk/reward ratio is a very important thing whether you are a trader or a long-term investor. In the past, we have seen some highly experienced professionals losing a fortune simply because they did not manage their risks well.
How risk/reward ratio works
Each trader should always know how to manage their risks as they try to achieve their trading goals. One of the most recommendations is that a trader should work to ensure that they don’t lose as much as 2% of their account per trade.
So, how does this work? Let us assume that you have a $10,000 account. In this case, your 2% will be $200. Therefore, if you open a trade, you should ensure that you don’t lose more than $200.
You can stop the trade automatically when your loss level reaches $200. Alternatively, you can set up a stop-loss that will do that for you automatically.
We have looked at the risk part. Now, to establish your reward, you can determine the amount of money that you want to make.
A common strategy used by experienced traders is to use a 1:1 ratio. In this case, if you are comfortable losing $200, you can set a goal of making a profit of $200. As such, you will either lose or make $200 in this trade.
Other traders have a different approach, where they are prepared to lose $200 with the goal of making a $100 profit. At the same time, others attempt to lose $100 with a profit target of $200.
Calculation of R/R ratio
There are several approaches of calculating the risk/reward ratio. The most basic one is where you subtract the stop-loss point from the entry point and then divide it with the difference of the profit target and the entry point. This can be summarized using the following calculation:
|Risk/Reward ratio = (Entry Point – Stop-loss) / (Profit target – entry point)|
Let us look at an example of this.
An asset is trading at $10 and you have a stop-loss at $8 and a take-profit at 12. In this case, the risk/reward ratio will be:
(10-8) / (12-10) = 1:1
In this trade, you are risking $2 with the aim of making $2.
This is the most basic way of calculating the RR ratio. However, most experts believe that it is actually an inadequate method.
Advanced: Add win and loss rate
One way of solving the inadequacies of this method is to include the concept of your win and loss rate. For example, if you typically open 10 trades per day and lose 3 of them, it means that you have a win/loss rate of 7:3. Therefore, your risk-reward ratio should include this concept.
The formula below will help you:
|E= [1+ (W/L)] x P – 1|
In this formula, the W is the size of your average win while L is the size of your average loss. P is the win rate that we have described above.
Here is an example of that. Assume that you typically win 8 trades out of 10. This means that you have a win ratio of 80%.
Next, if your 8 winning trades brought in $4,000, it means that your average win is $4,000/8, which is $500. If the 2 losses were $800, then your average loss is $400.
In this case, your RR ratio will be [1 + (500/400) x 0.80-1 = 1+1.25 x -0.2 = 1.05
Understand your RR ratio
Therefore, we have looked at what the risk-reward ratio is and how it works. Further, we have looked at an example of how to calculate it.
Therefore, as a trader, you should work out to establish where your ratio stands. With that understanding, you will be at a good position to make money while limiting your loss potential.
Pros and cons of having a risk/reward ratio
Some of the benefits of having a risk/reward ratio are:
- Capital preservation – When you have a good risk and reward ratio, you will be at a good position to preserve your capital.
- Discipline – It will help you to ensure that you are more disciplined in your trading. And this quality, for those who make trading their entire career, is crucial.
- Profit and loss expectations – With this ratio, you will be able to know what to expect when you open a trade.
The cons of having the ratio is that, at times, your win-loss ratio is not always accurate. Having this ratio in mind can also prevent you from opening a trade.
How to mitigate risks in trading
There are several strategies you can use to limit your risks in trading. These are:
- Having a stop-loss – As stated above, this is a tool that will stop the trade automatically when a certain loss threshold is reached.
- Having a take-profit – A take-profit stops a trade automatically when a certain profit level is reached.
- Leverage – Using a small amount of leverage can help to protect your trading account.
- Trade size – A big trade volume will expose you to more losses.
High-risk and high-reward assets
Financial are not always the same and some offer a high-risk and a high-reward situation. One of the most common high-risk and high-reward asset is a biopharma company. These firms spend millions of dollars researching a drug.
In this period, the company’s shares may be dropping because most people are unsure about whether the new drug will be approved.
Assume that the stock is trading at $3. If the drug is not approved, then the company’s stock could crash. But if it is approved, the shares could jump to $10. In this case, you are risking $3 to make a fortune. Examples of such companies were Moderna and Novavax.
Other high-risk, high-reward assets are cryptocurrencies and penny stocks.
Is a 1 to 1 r/r good?
The 1:1 ratio is the minimum acceptable ratio for traders and investors. It would not make sense to have a ratio with more losses than gains.
What is a good risk reward ratio?
From 1:1 ratios are all good. The best ones, in our opinion, are those that start from 1:3 or 1:4. This also depends a bit on your risk appetite.
How can a rare R/R affect day trading?
Sometimes the ratio estimate, along with the win-rate calculation, can lead to making the wrong decisions. Such as not entering a trade that turns out to be a good one.
A good risk/reward ratio is a savvy thing to have when trading. It is a very popular and highly effective risk management strategy, and in many cases it can save your trading account (along with all the others).
In this article, we have looked at the definition of that ratio. We have also assessed the pros and cons of the ratio and how to do a comprehensive calculation.
External useful resources
- Is a low risk-reward ratio really that bad? – Reddit