An Introduction to Risk-Reward Ratio
You should not be deceived by the risk-reward ratio because it is way beyond what it seems like at the initial stage. It is very possible to search for trades with a risk-reward ratio of say, 1:2, and consistently lose. Also, you can get trades with less than 1 risk-reward ratio and be a consistent winner.
This is so because the risk-reward ratio is not the entire equation, it is only a part. In this article, you will discover the depth of the risk-reward ratio and understand how to use it correctly.
What is the Risk-Reward Ratio?
The risk-reward ratio is used to measure the possible profit for every risked dollar. It is basically the ratio between the value that is at stake and the aimed profit. For instance, if you purchase a stock for $10 while you aim at making a profit of $12 and you have $9 as your stop-loss. The risk-reward ratio here is 1:2 because you're putting $1 at stake to make $2
The risk-reward ratio, usually referred to as RRR, is the number of dollars at stake in comparison to the possible profit. A lot of traders target a ratio like 1:2 before they place a trade. Therefore, the amount at risk, or the value at stake, is the total amount that can be lost on a trade.
How To Calculate The Risk-Reward Ratio
It is first imperative to understand that the risk-reward ratio is a metric used by traders to calculate how much they are putting at risk in the market for a reward. often, traders set their risk-reward ratios to 1:2, 1:3, or other similar ratios.
However, on its own, the risk-reward ratio does not give the trader any information, except it is paired up with the payout rate.
The moment the risk-reward ratio is paired up, calculating the success of your strategy, whether successful or not is much easier. Here is the formula for calculating the risk-reward ratio with a payout:
P = (1+(X/Y)) x Z - 1
The above formula is an important metric if you are in an attempt to use the risk-reward ratio to your advantage. The symbols in the above formula are explained as:
P = success rate
X = the size of average payouts
Y = the size of average losses
Z = payout rate
So, with the above information, it is very easy to begin the calculation of the success rate based on the history of trading.
Now, if the total payout was $4000 for example, that would mean that the average payout is $500 because apparently, 4000/8 = 500.
For unsuccessful trades, if for example, the net loss was $2000, this simply points out that the average loss is $1000 because 2000/2 = 1000.
Now, the information can be applied to the formula.
P = (1 + 500/1000) x 0.8 - 1
This would derive a success rate of 0.2 or 20%. Thankfully, this proves that trading has a positive success rate, which means that, the strategy or method is practicable.
As long as your risk-reward ratio gives you a good success rate, it is safe to use it. However, you can already tell that the ratio given as an example above was not what it eventually turned out to be.
If you do your calculations accordingly, the risk-reward ratio was concluded at 1:0.5, which does not seem like a feasible idea. But as proven otherwise, you can see now that even the most minimal risk-reward ratios can turn out to be very successful in the end.
Risk Vs Reward Explained
Basically, risk and reward in trading help investors to properly control their risks of making losses on trades. Even if a trader is making profitable sales consistently, he might begin to record losses after a while if his win rate drops below 50%.
What risk and reward help traders do is to measure the difference between a trade entry point, the stop-loss, and a take-profit order. The comparison helps to provide investors with the ratio at their expected profit to lose, or as it were, reward to risk.
Traders often make use of stop-loss orders when dealing with individual stocks to help reduce their losses and enable them to handle their investment with risk changes directly. Clearly, a stop-loss order can be referred to as a trading trigger that is put on a stock that automatically processes the trading of the stock if it falls below a specific standard. Investors can automate their stop-loss orders through the use of brokerage accounts that do not attract huge trading costs.
The risk-reward ratio is a feasible metric to make use of, but it must be personalized to suit certain demands such as your trading history, methods, and the general performance of various investors. For instance, if your trading strategy produces a negative outcome, you might want to change the approach and consider a reduced risk-reward ratio so that you can even out your chances.
Finally, considering that the risk-reward ratio is an unstable metric because of the constantly-changing market, which requires the trader to also change methods. Maintaining a particular strategy because it seems to produce a good payout rate does not mean it is applicable forever.
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