Should I risk my time to get rewarded with the information in this article?
The risk/reward ratio tells you how much risk you are taking for how much potential reward.
Good traders and investors choose their bets very carefully. They look for the highest potential upside with the lowest potential downside. If an investment can bring the same yield as another, but with less risk, it may be a better bet.
Interested to learn how to calculate this for yourself? Let’s read on.
- What is the risk/reward ratio?
- How to calculate the risk/reward ratio
- Risk vs. reward explained
- Closing thoughts
In this article, we’ll discuss how to calculate the risk/reward ratio for your trades.
What is the risk/reward ratio?
The risk/reward ratio (R/R ratio or R) calculates how much risk a trader is taking for potentially how much reward. In other words, it shows what are the potential rewards for each $1 you risk on an investment.
Now you’ve got both your entry and exit targets, which means you can calculate your risk/reward ratio. You do that by dividing your potential risk by your potential reward. The lower the ratio is, the more potential reward you’re getting per “unit” of risk. Let’s see how it works in practice.
How to calculate the risk/reward ratio
It’s worth noting that these generally shouldn’t be based on arbitrary percentage numbers. You should determine the profit target and stop-loss based on your analysis of the markets. Technical analysis indicators can be very helpful.
So, our profit target is 15% and our potential loss is 5%. How much is our risk/reward ratio? It is 5/15 = 1:3 = 0.33. Simple enough. This means that for each unit of risk, we’re potentially winning three times the reward. In other words, for each dollar of risk we’re taking, we’re liable to gain three. So if we have a position worth $100, we risk losing $5 for a potential $15 profit.
We could move our stop loss closer to our entry to decrease the ratio. However, as we’ve said, entry and exit points shouldn’t be calculated based on arbitrary numbers. They should be calculated based on our analysis. If the trade setup has a high risk/reward ratio, it’s probably not worth it to try and “game” the numbers. It might be better to move on and look for a different setup with a good risk/reward ratio.
Note that positions with different sizing can have the same risk/reward ratio. For example, if we have a position worth $10,000, we risk losing $500 for a potential $1,500 profit (the ratio is still 1:3). The ratio changes only if we change the relative position of our target and stop-loss.
The reward/risk ratio
It’s worth noting that many traders do this calculation in reverse, calculating the reward/risk ratio instead. Why? Well, it’s just a matter of preference. Some find this easier to understand. The calculation is just the opposite of the risk/reward ratio formula. As such, our reward/risk ratio in the example above would be 15/5 = 3. As you’d expect, a high reward/risk ratio is better than a low reward/risk ratio.
Example trade setup with a reward/risk ratio of 3.28.
Risk vs. reward explained
Let’s say we’re at the zoo and we make a bet. I’ll give you 1 BTC if you sneak into the birdhouse and feed a parrot from your hands. What’s the potential risk? Well, since you’re doing something you shouldn’t, you may get taken away by police. On the other hand, if you’re successful, you’ll get 1 BTC.
At the same time, I propose an alternative. I’ll give you 1.1 BTC if you sneak into the tiger cage and feed raw meat to the tiger with your bare hands. What’s the potential risk here? You can get taken away by police, sure. But, there’s a chance that the tiger attacks you and inflicts fatal damage. On the other hand, the upside is a little better than for the parrot bet, since you’re getting a bit more BTC if you’re successful.
Which seems like a better deal? Technically, they’re both bad deals, because you shouldn’t sneak around like that. Nevertheless, you’re taking much more risk with the tiger bet for only a little more potential reward.