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risk reward ratio

What is a Risk/Reward Ratio for Trader and How to Use It

The risk/reward ratio tells you how much risk you are taking for a potential reward.

Good traders and investors choose their bets very carefully. They look for the rise of the highest potential with the lowest potential decline. Although the investment can yield the same return as any other investment, it may be a better option if it involves less risk.

Would you like to learn how to calculate this? Let’s read on.

Introduce

Whether you are day trading or swing trading, there are some basic concepts of risk that you need to understand. It forms the basis for understanding the market and provides a basis for guiding trading activities and investment decisions. Otherwise, you will not be able to protect and grow your trading account.

We have already discussed risk management, position-sizing, and setting up loss prevention. However, there is a crucially important thing to understand if you are actively trading. How much risk are you taking with respect to potential rewards? How does the potential upside compare to the potential downside? That is, what is the risk/reward ratio?

This article explains how to calculate the risk/reward ratio for a trade.

What is the risk/reward ratio?

The risk/reward ratio (R/R ratio or R) calculates the risk a trader is taking in order to potentially receive a reward. In other words, it shows you what the potential reward is for every dollar of risk on your investment.

The calculation itself is very simple. Divide the maximum risk by the net target profit. How do you do it? First, determine where you want to start trading. You then decide where to profit (if the trade is successful) and where to put the Stop Loss (if it is a losing trade). It is important to properly manage risk. A good trader sets a profit target and stop loss before entering a trade.

Now that we have both the entry and exit objectives, we can calculate the risk/reward ratio. All you have to do is divide the potential risk by the potential reward. The lower the ratio, the more potential rewards you can get per unit of risk. Let’s see how it actually works.

How the risk/reward ratio is calculated

Let’s say you want to enter according to the position of bitcoin. You do an analysis and determine that the take-profit order will be 15% of the entry price. At the same time, it also raises the following questions: Where is the trade idea invalidated? This is where you need to set up a Stop Loss order. In this case, we determine that the invalidation point is 5% from the entry point.

In general, it should not be based on random percentage numbers. You need to determine your profit target and Stop Loss based on your market analysis. Technical analysis indicators can be very useful.

So our profit target is 15% and our potential loss is 5%. What is our risk/reward ratio? 5/15 = 1:3 = 0.33. Simple enough. This means that for each risk unit you have potentially earned 3x the reward. In other words, for every dollar you risked, you could earn $3. So, if you have a position worth $100, you risk losing $5 for a potential profit of $5.

You can move the Stop Loss closer to the entry point to lower the ratio. But as we said, entry and exit points should not be calculated based on random numbers. It should be calculated based on our analysis. If your trade setup has a high risk/reward ratio, the numbers probably aren’t worth trying out. Moving on, you might be better off looking for other settings with good risk/reward ratios.

Positions of different sizes can have the same risk/reward ratio. For example, if you have a position worth $10,000, you risk losing $500 for a potential profit of $500 (the ratio is still 1:3). The percentage will only change if you change the relative positions of the target and the Stop Loss.

Reward/risk ratio

It is worth noting that many traders calculate the reward/risk ratio by doing this calculation in reverse. why? Well, it’s just a matter of preference. Some people find this easier to understand. The calculation is the exact opposite of the risk/reward ratio formula. So in the example above, the reward/risk ratio would be 15/5 = 3. As expected, a high reward/risk ratio is better than a low reward/risk ratio.

Risk vs. Reward Description

Let’s say we were at the zoo and we made a bet. If you sneak into the birdhouse and feed the parrot out of your hand, it will give you 1 BTC. What are the potential risks? Well, you might get pulled over by the police for doing something you shouldn’t. On the other hand, if you succeed, you will receive 1 BTC.

At the same time, we propose alternatives. If you sneak into the tiger cage and feed the tiger raw meat with your bare hands, I will give you 1.1 BTC. What are the potential risks here? Of course, you can be taken away by the police. However, there is a chance that the tiger will attack you and inflict lethal damage. On the other hand, the upside is slightly better than the farad bet, as you will receive a bit more bitcoins if you succeed.

Which one seems like a better deal? Technically, both are bad deals. Nevertheless, you take a lot more risk with a Tiger bet for more potential rewards.

In a similar way, many traders will find trading setups in which they stand to gain much more than they will lose. This is called an asymmetric opportunity (potential upside outweighs potential downside).

The important thing to mention here is the win rate. Your win rate is the number of trades you win divided by the number of trades you lose. For example, if you have a 60% win rate, you are making money on 60% (average) of your trades. Let’s see how we can use it in risk management.

Nevertheless, some traders can make high profits with very low win rates. why? This is because the risk/reward ratio of the individual trade setup accommodates this. If you only set it up with a risk/reward ratio of 1:10, you could lose 9 trades in a row and still break even in one trade. In this case, they only need to win 2 out of 10 trades to make a profit. This is how risk versus reward calculations are powerful.

Final thoughts

We looked at what the risk/reward ratio is and how traders can incorporate it into their trading plans. Calculating the risk/reward ratio is essential when it comes to the risk profile of your money management strategy.

Something worth considering the risk is keeping a trading journal. Documenting your trades gives you a better picture of how your strategy is performing. It can also potentially adapt to different market environments and asset classes.