Updated July 21, 2023
Introduction to Risk Reward Ratio
A Risk Reward Ratio is the measure of return generated from the perspective of a risk taken over a specified period of time which generally takes a starting period or point of time and ending period or point of time and compares how the reward on investment has been i.e. in terms of trade it can mean the difference between trade entry point and the profit booking/ sell order point.
It is defined as the percentage return obtained on the basis of taking a risk in the field of trade or investment. Generally, there are two points involved which include the trade entry point and the trade profit booking point. The risk-reward ratio can also be defined as a measure to measure the profit-making potential to loss-making potential. Here both the profit and loss-making potential must be defined by the trader beforehand.
Trade risk is defined by setting up a stop-loss order where risk is the difference in price between the trade start point and the stop-loss point. A target point is defined as the exit point provided the trade moves in a favorable direction. A potential point of the profit is the price difference between the targeted profit and the price at which trade was entered.
How Does Risk Reward Work?
- This ratio can be considered as a benchmark or a measure when traders deal with individual shares of stock. The best technique to use the risk-reward strategy will vary from trade to trade and thus strategy varies accordingly. The use of a trial and error method is a must to come to a conclusion about choosing the best ratio for a particular trade strategy. Also, many investors will have their own predefined ratio value for their own investments.
- It is generally observed that strategists prevailing in the market generally look for a 1:3 risk-reward ratio for their investments. This means there are three units of return generated whenever the trader takes every one unit of the risk. This relationship can be better handled by the traders/investors when they couple their trade strategy with the usage of stop-loss orders and other hedging instruments in the field of derivatives like a put option.
- It generally gives protection to investors to manage their risk of losing money in the market. If the win rate is below 50% every trader is bound to lose money in the market. Comparing the stop-loss and take-profit gives us a measure of the ratio of profit to loss or reward to risk. Investors use the risk-reward ratio to help them keep the loss to bare minimum and manage their investment with a focus of risk-reward perspective.
How is the Risk Reward Ratio Calculated?
- In layman’s word risk-reward ratio involves more of setting up a stop-loss point and profit booking point when a trader or investor is trading an individual share or stock. Suppose, we being an investor we purchase a share of a company for $50 and based on our analysis we believe we can make a profit from the stock and set out a profit booking limit as $70. So basically this means the stock will go high in terms of value but we plan to exit the stock as soon as it touches $65 mark.
- Also, we find that the base level the stock can hit is $44 so based on that we set a stop loss of $45 for the stock. Thus we can see now we have two major benchmarks i.e. the risk based on the stop loss we have set which is $5 and also the expected reward which is $20. So thus when we want to calculate the risk-reward ratio, in this case, we simply divide the risk number with the reward number which we have. In this case, we have $5:$20 = 1:4. Thus it means for every unit of risk which we take we fetch 4 units of reward or return.
Example of Risk Reward Ratio
An example of a risk-reward ratio can be a case of investing in stock after setting up a stop loss point and a profit booking point. So suppose we take here into consideration a single share of Microsoft Corporation which is currently trading at $183 for a single share. A trader who wants to invest it in will set a stop loss of around $ 170 and also the stock has enough potential to generate returns and may climb to $220. Thus we see the risk associated here is $13 and the expected reward is $ 37. So thus when we want to calculate the risk-reward ratio, in this case, we simply divide the risk number with the reward number which we have. In this case we have $13:$37 = 1:3. Thus it means for every unit of risk which we take we fetch 3 units of reward or return.
Importance of Risk Reward Ratio
Following are the important are given below:
- It helps investors manage the risk of losing their hard-earned money in the process of trading.
- It helps in setting up a stop loss point and a profit booking point for every individual trade.
- It sets up a relation between the size or magnitude of the stop loss and the size of the target profit to be booked.
- The risk to reward ratio acts as providing a direction for the continuation of the trade.
- It acts as a cheering factor in the field of trading even for those who are not regular players in the stock market.
It is a very important benchmark used in the field of trading. It helps investors manage the risk of losing their hard-earned money in the process of trading. It helps in setting up a stop loss point and a profit booking point for every individual trade. A proper evaluation of this ratio can do wonders in the field of profit booking or earning handsome returns.
This is a guide to Risk Reward. Here we discuss the working, importance & calculation of the risk-reward ratio along with an example. You may also look at the following articles to learn more –