Investing is a risk-reward endeavor.
For any anticipated reward, there is a level of risk which the investor has to bear. The rule of thumb is that the rewards have to outweigh the risk. This implies that before you place a trade or invest, the rewards from such action have to outweigh the risk of not participating or your losses.
However, many investors do not factor this important metric into their trading strategies. Most new investors and traders execute orders where the risk is much higher than the reward. This is the reason why most people accumulate losses and blow up their accounts.
This article highlights the importance of risk-reward and how you can use it to formulate profitable investing and trading strategies.
What is the risk-reward ratio?
The risk/reward ratio indicates how much money an investor may potentially make for every dollar they risk on an investment.
Many investors utilize risk/reward ratios to evaluate an investment’s predicted returns to the risk they must take to attain those returns.
Consider the following illustration:
A risk-reward ratio of 1:5 indicates that an investor is ready to risk $1 in exchange for the possibility of earning $5. A risk/reward ratio of 1:3 indicates that an investor should anticipate investing $1 in exchange for the possibility of earning $3.
The ratio is computed by dividing the amount a trader stands to lose if the price of an asset moves in an unanticipated direction (the risk) by the amount of profit the trader anticipates to have gained when the position is closed (the reward).
How to use the risk/reward ratio
The risk-reward ratio entails knowing your anticipated profit and your expected loss before you enter a trade.
Risk is the total amount that could be lost. It is the difference between the entry point for the trade and the stop-loss order. Reward, on the other hand, is the profit objective as established by the take-profit point. It is the difference between the profit objective and the entrance point is the profit margin.
The ideal risk-reward ratio for most investors is 1:3. This entails your profit should be three times the amount you invested. When trading securities, after your technical and fundamental analysis, have been conducted, it is now time to choose your price target.
This is where most traders flout. Provided the TA and FA support their trade, they enter the market.
However, experienced traders still look at one more condition: risk/reward ratio. If the reward is not three times the risk, they leave the trade even though the market would move in their anticipated direction.
For example, if you notice that the market is entering a bullish phase, but your TA indicates that a 1:1 risk-reward ratio, more experienced traders would not enter the trade. While new traders may see this move as leaving money on the table, it is a logical move if you want to be a profitable trader or investor.
This is because no one knows how the market may change. As a trader, you are betting on probabilities. As such, you have to be sure that what you are betting on is worth your money and time.
Importance of risk-reward ratio
The risk-reward ratio is a viable risk management technique that tilts the balance of trades in your favor.
Let’s consider the following scenario.
- Imagine you place 5 trades with a risk-reward ratio of 3:1 at $100 each.
- Out of the five trades, you lost three and won two.
- This brings your total profit to $600, even though you have lost $300 in three other trades.
So you can see even though you had a less number of profitable trades, you are still able to make a profit in your overall portfolio.
Limitations of the risk/reward ratio
A low risk/reward ratio does not reveal all of the information you need regarding a transaction. You’ll also need to know how likely it is that you’ll meet those goals.
A typical error made by day traders is to analyze a transaction with a specific risk/reward ratio in mind. This might encourage traders to set their stop-loss and profit objectives based on the entry point rather than the security’s value, without considering the market circumstances.
Key takeaway
Choosing the optimum risk/reward ratios requires a delicate balance between choosing trades that provide more profit than risk and ensuring that the transaction has a fair possibility of hitting the objective before the stop loss.
To employ the risk/reward ratio efficiently, you’ll need a trading strategy that establishes:
- acceptable market circumstances
- suitable entry and exit points
- the stop-loss and take-profit levels
However, this should not be the pivot of your trading strategies, as it should be used in accordance with other factors.
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