The risk/reward ratio (R/R ratio) allows traders and investors to gauge their trades and see how much reward will be likely in respect to the risk they are willing to take. By using the risk/reward ratio, they will be able to compare different investment decisions and see which one would give them a higher reward for a lower risk.
The risk/reward ratio can be presented as a single number or we can have the value of risk and reward next to each other. For instance, a risk/reward ratio of 1:4 shows that the reward will be 4 times higher than the risk. In other words, you can earn $4 for each $1 you are willing to invest (risk).
The risk/reward ratio can be a powerful tool in trading and investment and can help traders and investors to manage their risk exposure more effectively.
Now, let’s dig a bit deeper into this tool and see how you can use the risk/reward ratio in trading to have lower risks and higher wins.
Risk is an inevitable part of an investment that cannot be ignored. As a trader or investor, you can only accept this fact and try to find ways to manage your risk to limit your loss while maximizing your profits.
To manage your risk exposure, you would need to calculate your potential loss and then compare it with the potential reward to see if it does worth the risk. This is exactly what the risk/reward ratio allows you to see by presenting it as simple numbers.
The risk/reward ratio can be quite helpful for comparing different trading or investment opportunities. It can also be used for assessing strategies.
We have various types of trading strategies that are suitable for different traders with diverse preferences. Some of these strategies are quite successful in short-term trading while others would perform best when used for long-term investments. However, choosing the proper strategy can be quite challenging.
Here, traders can apply the risk/reward ratio to different strategies to have a better understanding of their potential profit with respect to their potential loss and choose the strategy that offers the best outcome.
The calculation of the risk/reward ratio (R/R ratio) is quite simple. You just need to divide your potential loss by the potential profit to get the ratio of these two.
Here’s the formula for the risk/reward ratio:
R/R Ratio = Potential Loss/ Potential Profit
The potential loss and profit can be calculated in different ways. Traders and investors can look into past market data and try to assess the probability of the market price going in favor or against their prediction. They can also use fundamental analysis in their potential risk and reward calculation.
You should remember that these calculations are merely calculations and the actual loss or profit can be quite far from the initial estimations. Considering this, you should always know your own risk tolerance based on the available capital and your personal goals.
In this way, you would be completely ready if the assumed loss or profit and the calculated risk/reward ratio didn’t quite match with the market movements.
Now, let’s see how we can use the risk/reward ratio in trading.
Let’s explain the R/R Ratio with an example.
Let’s assume that Bitcoin is trading at $25,000. You’ve been analyzing the Bitcoin market for a while and have used different technical indicators to assess its short-term price movement. You are confident that the price of Bitcoin will reach $30,000 in the near future so you buy 10 Bitcoins for 250,000 dollars.
To stay on the safe side, you also consider the chance of the price going against your prediction so you place a stop-loss order at $24,500 to limit your potential loss.
Now, let’s do some quick math to calculate your potential loss and profit and then use them to have the actual R/R ratio.
If the price reaches $30,000 as you predicted, you will make $5000 per Bitcoin which will bring your total profit to $50,000. On the other hand, if the market moves against your prediction, your bitcoins will get sold with a $500 loss per Bitcoin which makes your total loss $5000.
In this case:
R/R Ratio = Potential Loss/ Potential Profit = 5000 /50000 = 0.1
This is a very impressive number for the R/R ratio and shows a great profit.
In general, you can read the R/R ratio as follow:
The risk/reward ratio is a very simple tool that can help traders and investors to manage the risk in their investments. It can be calculated quite easily, making it a suitable tool for users with any level of proficiency.
With the risk/reward ratio, we can quickly have an overall assessment of our investment opportunities. However, this tool may not be as accurate as we need.
As mentioned above, we need to consider our risk appetite along with the risk/reward ratio as the outcome may be quite different than the assumed risk and reward. This can be considered as a limitation for the risk/reward ratio as it does not include the probability of these assumptions.