Whether you’re day trading or swing trading, there are a few fundamental concepts about risk that you should understand. These form the basis of your understanding of the market and give you a foundation to guide your trading activities and investment decisions. Otherwise, you won’t be able to protect and grow your trading account.
What is the risk/reward ratio?
The risk/reward ratio (R/R ratio or R) calculates how much risk a trader is taking for potentially how much reward. In other words, it shows what are the potential rewards for each $1 you risk on an investment.
The calculation itself is very simple. You divide your maximum risk by your net target profit. How do you do that? First, you look at where you would want to enter the trade. Then, you decide where you would take profits (if the trade is successful), and where you would put your stop-loss (if it’s a losing trade). This is crucial if you want to manage your risk properly. Good traders set their profit targets and stop-loss before entering a trade.
Now you’ve got both your entry and exit targets, which means you can calculate your risk/reward ratio. You do that by dividing your potential risk by your potential reward. The lower the ratio is, the more potential reward you’re getting per “unit” of risk. Let’s see how it works in practice.
How to calculate the risk/reward ratio
Let’s say you want to enter a long position on Bitcoin. You do your analysis and determine that your take profit order will be 15% from your entry price. At the same time, you also pose the following question. Where is your trade idea invalidated? That’s where you should set your stop-loss order. In this case, you decide that your invalidation point is 5% from your entry point.
It’s worth noting that these generally shouldn’t be based on arbitrary percentage numbers. You should determine the profit target and stop-loss based on your analysis of the markets. Technical analysis indicators can be very helpful.
So, our profit target is 15% and our potential loss is 5%. How much is our risk/reward ratio? It is 5/15 = 1:3 = 0.33. Simple enough. This means that for each unit of risk, we’re potentially winning three times the reward. In other words, for each dollar of risk we’re taking, we’re liable to gain three. So if we have a position worth $100, we risk losing $5 for a potential $15 profit.
We could move our stop loss closer to our entry to decrease the ratio. However, as we’ve said, entry and exit points shouldn’t be calculated based on arbitrary numbers. They should be calculated based on our analysis. If the trade setup has a high risk/reward ratio, it’s probably not worth it to try and “game” the numbers. It might be better to move on and look for a different setup with a good risk/reward ratio.
Note that positions with different sizing can have the same risk/reward ratio. For example, if we have a position worth $10,000, we risk losing $500 for a potential $1,500 profit (the ratio is still 1:3). The ratio changes only if we change the relative position of our target and stop-loss.
The reward/risk ratio
It’s worth noting that many traders do this calculation in reverse, calculating the reward/risk ratio instead. Why? Well, it’s just a matter of preference. Some find this easier to understand. The calculation is just the opposite of the risk/reward ratio formula. As such, our reward/risk ratio in the example above would be 15/5 = 3. As you’d expect, a high reward/risk ratio is better than a low reward/risk ratio.
Example trade setup with a reward/risk ratio of 3.28.
Risk vs. reward explained
Let’s say we’re at the zoo and we make a bet. I’ll give you 1 BTC if you sneak into the birdhouse and feed a parrot from your hands. What’s the potential risk? Well, since you’re doing something you shouldn’t, you may get taken away by police. On the other hand, if you’re successful, you’ll get 1 BTC.
At the same time, I propose an alternative. I’ll give you 1.1 BTC if you sneak into the tiger cage and feed raw meat to the tiger with your bare hands. What’s the potential risk here? You can get taken away by police, sure. But, there’s a chance that the tiger attacks you and inflicts fatal damage. On the other hand, the upside is a little better than for the parrot bet, since you’re getting a bit more BTC if you’re successful.
Which seems like a better deal? Technically, they’re both bad deals, because you shouldn’t sneak around like that. Nevertheless, you’re taking much more risk with the tiger bet for only a little more potential reward.
In a similar way, many traders will look for trade setups where they stand to gain much more than they stand to lose. This is what’s called an asymmetric opportunity (the potential upside is greater than the potential downside).
What’s also important to mention here is your win rate. Your win rate is the number of your winning trades divided by the number of your losing trades. For example, if you have a 60% win rate, you are making profit on 60% of your trades (on average). Let’s see how you can use this in your risk management.
Even so, some traders can be highly profitable with a very low winning rate. Why? Because the risk/reward ratio on their individual trade setups accommodates for it. If they only take setups with a risk/reward ratio of 1:10, they could lose nine trades in a row and still break-even in one trade. In this case, they’d only have to win two trades out of ten to be profitable. This is how the risk vs. reward calculation can be powerful.
We’ve looked at what the risk/reward ratio is and how traders can incorporate it into their trading plan. Calculating the risk/reward ratio is essential when it comes to the risk profile of any money management strategy.
What’s also worth considering when it comes to risk is keeping a trading journal. By documenting your trades, you can get a more accurate picture of the performance of your strategies. In addition, you can potentially adapt them to different market environments and asset classes.