The relationship between risk and reward is important for traders to understand because it looks at the potential upside vs. downside of a trade. Specifically, risk/reward analysis looks at the amount of money you could make for every 1 USD you invest.
This article at a glance:
The risk-reward ratio helps to understand how much you can potentially earn for every 1 USD invested.
If the reward is too low vs. the risk, it's not a good trade. If the potential reward is high vs. the risk, it's a good trade.
Risk/reward analysis is not 100% accurate but is helpful to limit any losses, while maximising the earning potential of your trades.
What is the Risk to Reward Ratio (RRR)?
Risk to reward (RR) ratio looks at the amount of money you could make for every dollar you're risking in a trade. It's an X to Y ratio. For example, a ratio of 2:1 means you could make 2 USD for every 1 USD you risk.
Traders use this information to assess the potential of a trade. If the reward is too low vs. the risk, it's not a good trade. If the potential reward is high vs. the risk, it's a good trade. That's a basic way of putting it, but it all depends on how you define the different variables in the trade.
By variables, we mean that you need to assess the potential profit and loss of a trade to properly define the risk and reward. Comparing risk to reward allows you to see how viable a trade might be. Here, potential risk is the amount you could lose on a trade. Similarly, potential profit is the amount you could make on a trade.
You can’t be 100% accurate when defining profit and loss. But, based on your research, you need to set logical estimates.
Further, the risk and return relationship isn’t based on absolute facts because you can’t know the exact amount of profit/loss of a trade you haven’t even made yet. But you can set your own profit/loss limits based on your assessment of the market.
How to calculate the risk reward ratio?
Calculating the RR ratio requires you to define and compare the potential cost of your investment and the amount of net profit you could make. Divide the profit by the loss to get a risk score. Then, compare this score to your profit potential as a ratio, e.g. 1:3 (1 USD risk for every 3 USD of profit), or simply as 0.33 (1 divided by 3).
Risk-reward ratio = Total potential profit
Total potential loss
Example 1: Risk/return ratio formula
We buy 10 shares in a company and each share costs 20 USD. The total cost for the trade was 200 USD.
We believe the company's share price will go up to 25 USD.
The potential profit per share of this trade would be 5 USD.
Owning 10 shares would give us a profit of 50 USD.
If our assessment is incorrect, and the share price decreases, we lose money.
Without a stop-loss limit, our total risk is 100% of the trade's value, i.e. 200 USD.
We can put this information into a risk/return ratio formula:
Divide 250 USD (total potential profit) by your potential loss of 200 USD to get your risk to reward ratio.
250 / 200 = 1.25
The risk to reward ratio is 1:1.25, or 0.8.
By trading without a stop-loss limit, 100% of our investment is exposed. Traders typically use stop-loss limits to manage risk. This caps the downside on a trade, therefore improving the risk to reward ratio.
Example 2: Risk/return ratio formula
Let’s say we set a stop-loss at a share price of 16 USD. That means the trade gets closed if the share price drops from 20 USD to 16 USD. Because we own 10 shares, that means we'd incur a total loss of 160 USD (instead of 200 USD in Example 1).
Setting this stop-loss limit will change the risk to reward ratio:
Divide 250 USD (total potential profit) by your potential loss of 160 USD to get your risk to reward ratio.
250 / 160 = 1.56
The risk to reward ratio is 1:1.56, or 0.6.
You can see how in this way, using stop loss limits can help to improve your risk-return ratio.
What is considered a good risk/reward ratio for different types of traders?
The risk to reward ratio that traders typically look for is 1:3 or higher. That means a trader will risk a 1 USD loss for every 3 USD of potential profit. However, more experienced or risk-friendly traders may choose to use 1:2 or even lower.
Remember that these limits should be used as a guide. Practice your trading strategies with different risk-reward ratios through our demo account to find one that works for you.
This material is for general information purposes only and is not intended as (and should not be considered to be) financial, investment or other advice on which reliance should be placed. INFINOX is not authorised to provide investment advice. No opinion given in the material constitutes a recommendation by INFINOX or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
All trading carries risk.