Most traders spend their time studying the price chart, looking at the historic data and looking for the next big opportunity. While these are constructive activities that everyone needs to attend to, not every trader takes the time to focus on the potential loss or profit relative to the risk taken.
Knowing what’s a good risk-to-reward ratio can help plan a proper risk management strategy and also determine whETHer you’re going to be a profitable trader in the long run and achieve your financial goals. Whether you’re a beginner or experienced trader, this guide will introduce you to the nuts and bolts of the risk/reward ratio, and how to calculate risk reward ratio as part of risk management to minimize losses.
What Is the Risk/Reward Ratio?
The risk/reward ratio defines the relationship between the potential hazards and gains for any given trade. It is a process to assess the difference of entry points, stop loss to take profit orders based on the RR ratio. In every trading strategy, the ideal approach is to get maximum reward against minimum risk.
Traders can identify risk by finding the price gap between the opening point and the stop-loss order. On the other hand, the profit targets indicate a price level where a trader should get out of the market with a considerable gain. Traders can identify the take profit level by measuring the distance between the entry point and the profit target.
The stop-loss trading order automatically sells the instrument once the price reaches the lowest determined price level. Thus, it minimizes the potential risk by allowing an investor to get out of the market without experiencing further losses. If the market reaches the stop-loss level, the order will automatically close to prevent further loss on the trading account if the price drops even lower.
The relationship between the stop loss and take profit helps to identify the ideal reward from potential risk. Taking these measures is an active way to hone your trading strategy.
How to Calculate Risk Reward Ratio
Traders should calculate the risk they are taking per trade vs. the reward they are getting in order to determine the risk/reward ratio. In manual trading, traders analyze and set these levels before opening a position.
Risk is the amount of money a trader will lose, as determined by the stop-loss order. In other words, it is the gap between the stop-loss order and the entry price. Similarly, the reward is the potential profit set by the trader. We can measure it by calculating the distance between the entry point and the profit target.
The risk/reward ratio is the quotient we obtain when dividing the risk dividend by the reward and we can calculate it following this simple formula:
Risk/Reward (R/R) Ratio = (Entry Point - Stop Loss Point) / (Profit Target - Entry Point)
If the ratio is greater than 1, you have taken a lower risk to get higher returns. The three possible outcomes of the calculation are as follows:
- Risk > Reward
- Risk < Reward
- Risk = Reward
Among these three cases, we aim to keep the risk lower than the reward so that every time the trade hits the stop loss, your loss is minimized. The ultimate goal is to keep the risk as low as possible in every trade to keep the potential profit at a certain level.
What Does the RR Ratio Tell you?
Finding the trend in the volatile cryptocurrency market can be challenging regardless if you’re using technical analysis or fundamental analysis. The risk/reward ratio remains one of the most important risk management tools to help critically identify a trade entry point to a stop-loss or take-profit order.
Traders usually identify the price direction by using multiple technical and/or fundamental tools. However, even if you follow a good trading strategy, there’s always the possibility of losses, as no one knows the future. Therefore, the significant volatility and the possibility of a market crash make using the risk/reward ratio compulsory for cryptocurrency trading.
As such, using stop losses in every trade is compulsory for all traders. Moreover, it can help you increase the probability of winning trades. It isn’t wise to risk all of your investment in a single trade, nor does it make sense to risk $1,000 for a $100 gain. Again, most analysts advise a risk/reward ratio of no greater than 1:2, or 0.5, for recommended trades.
What is a Good Risk/Reward Ratio Crypto?
In every trading strategy, obtaining higher returns is the primary goal. That’s why a risk/reward ratio of 1:2, i.e., with a maximum value of 0.5, is recommended. However, there are no fixed rules of use, as it depends on the expectation and the strategy one uses.
Let’s have a look at the concept of trading expectancy, or the average profit for each trade placed by an investor, using the following formula:
E = [1 + (W/L)] × P − 1
Where:
- W = Average win
- L = Average loss
- P = Winning rate
Finding the expectancy and matching it with the risk/reward ratio is important for day traders and swing traders. For example, if you make ten trades of which six are profitable, your win rate is 6/10 or 60%.
Now, let’s say that of those ten trades from which you make a profit, you earn $6,000 while losing $2,000 on your four losing trades. Then your average win should be $6,000/6 = $1,000, while the four losing trades with $2,000 loss produce an average loss of $2,000/4 = $500. Applying the formula:
E= [1+ (1000/500)] x 0.6 – 1 = 0.80
Therefore, your trading expectancy of 80% is very high.
Closing Thoughts
We’ve looked at what the risk/reward ratio is and how to calculate risk reward ratio so that traders can incorporate it into their trading plan. Calculating the 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.
