Risk-to-reward Ratio

Definition

The risk to reward ratio is used to evaluate the profit potential of a particular trade in comparison to its potential for loss. In other words, it is used to calculate how much a trader is willing to risk on a trade against how much profit he plans to aim for.

It is an essential risk and money management technique that should be applied to every trade before it is executed.

The idea behind this theory is to find trades which offer a greater potential for a reward than risk.

How to calculate risk-to-reward ratio

If a trader is willing to risk losing $0.10 on trade while hoping to make a $0.25 potential profit, the risk to reward ratio is calculated as such:

$0.10/$0.25 = 0.4

As a general rule of thumb in the online trading industry, if the risk/reward ratio is greater than 1.0, it means that the trader is taking a greater risk compared to the potential return. On the other hand, a less than 1.0 ratio means that the trader has a better chance of making a profit relative to making a loss.

Using the risk-to-reward ratio

Most traders use the stop loss and take profit options to ensure that their risk-to-reward ratio is respected as not everyone has the time to constantly stay in front of our screen waiting for the set amounts to be reached.

Taking the above example, if the asset is priced at $45.70, the trader will set his stop losses and take profits as follows:

  • Stop loss

($45.70-$0.10) = $45.60

  • Take profit

($45.70+$0.25) = $45.95

This means that if the price of the asset is decreasing, as soon as it hits $45.60, the position will be automatically closed and likewise, as soon as it reaches $45.95, the position will be immediately closed.

Proceeding with caution

Using this risk management technique does has its upsides but traders must proceed with caution as there is always the possibility that the price of the asset traded reaches the stop loss limit before going back up and hitting the take profit limit.

If a trader goes with a 1:3 risk-to-reward ratio during 10 consecutive trades and only wins half of the trades, he will still make a profit. The table below illustrates this clearly:

Trades Number Loss Win
1 $1,000
2 $3,000
3 $1,000
4 $3,000
5 $3,000
6 $1,000
7 $3,000
8 $1,000
9 $1,000
10 $3,000
TOTAL $5,000 $15,000

Even after losing half of his trades, the trader still makes a profit:

  • Net profit

$15,000-$5,000 = $10,000

Hence, traders must use the risk-to-reward ratio, while taking the market conditions into account. Having a good trading strategy and sticking to it will help traders become successful in the long run.